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Full text of "Description of the Technical Corrections Act of 1987 (H.R. 2636 and S. 1350)"

[JOINT COMMITTEE PRINT] 



DESCRIPTION OF THE 

TECHNICAL CORRECTIONS ACT OF 1987 

(H.R. 2636 and S. 1350) 



Prepared by the Staff 



OF THE 



JOINT COMMITTEE ON TAXATION 




JUNE 15, 1987 



U.S. GOVERNMENT PRINTING OFFICE 

WASHINGTON : 1987 JCS- 15-87 



For sale by the Superintendent of Documents, U.S. Government Printing Office 
Washington, DC 20402 



SUMMARY CONTENTS 



Page 

Introduction xv 

Title I. Technical Corrections to the Tax Reform Act of 

1986 1 

I. Individual Income Tax Provisions 1 

II. Capital Cost Provisions 9 

III. Capital Gains and Losses 19 

IV. Agriculture Provisions 21 

V. Tax Shelters; Interest Expense 23 

VI. Corporate Tax Provisions 28 

VII. Minimum Tax Provisions 61 

VIII. Accounting Provisions 64 

IX. Financial Institutions 74 

X. Insurance Provisions 78 

XL Pensions and Deferred Compensation; Employee 

Benefits; ESOPs 86 

XII. Foreign Tax Provisions 167 

XIII. Tax-Exempt Bond Provisions 241 

XIV. Trusts and Estates; Minor Children; Generation- 

Skipping Transfer Tax 257 

XV. Compliance and Tax Administration Provisions 271 

XVI. Exempt and Nonprofit Organizations 279 

XVII. Miscellaneous Provisions 282 

Title II. Technical Corrections to Other Tax Legislation 290 

A. The Superfund Revenue Act of 1986 290 

B. The Harbor Maintenance Revenue Act of 1986 293 

C. The Omnibus Budget Reconciliation Act of 

1986 295 

(III) 



CONTENTS 



Page 

Introduction xv 

Title I. Technical Corrections to the Tax Reform Act of 

1986 1 

I. Individual Income Tax Provisions (Section 101 of 

THE Bill) 1 

1. Rate of tax with respect to certain un- 
claimed cash 1 

2. Rate of accumulated earnings tax 1 

3. Standard deduction and filing requirement 

for elderly or blind dependents 2 

4. Rule for inflation adjustments to earned 
income credit 3 

5. Cross-references to scholarship exclusion 
provisions in private foundation rules 3 

6. Treatment of certain scholarship or fellow- 
ship grants to nonresident aliens 4 

7. Coordination of two-percent floor and cer- 
tain other deduction limitation provisions .... 5 

8. Application of two-percent floor to trusts 

and estates 6 

9. Clarification of exceptions to certain rules 
limiting meal and entertainment deductions 7 

10. Carryover of excess home office deductions... 8 

II. Capital Cost Provisions (Section 102 of the Bill).... 9 

A. Depreciation and Regular Investment Tax Credit . 9 

1. Depreciation 9 

2. Investment tax credit 12 

B. Rapid Amortization Provisions 14 

1. Trademark and trade name expenditures 14 

2. Railroad grading or tunnel bores 14 

C. Real Estate Provisions 14 

1. Tax credit for rehabilitation expenditures 14 

2. Tax credit for low-income rental housing 15 

III. Capital Gains and Losses (Section 103 of the Bill) . 19 

1. Individual and corporate capital gains 19 

2. Incentive stock options 19 

(V) 



VI 

Page 

IV. Agriculture Provisions (Section 104 of the Bill).... 21 

1, Treatment of discharge of indebtedness 
income of certain farmers , 21 

2. Retention of capital gains treatment for 
sales of dairy cattle under milk production 
termination program 21 

V. Tax Shelters; Interest Expense (Section 105 of the 

Bill) 23 

1. Passive loss rules 23 

2. Investment interest limitation 25 

3. Personal interest limitation 26 

VI. Corporate Tax Provisions (Section 106 of the Bill) 28 

A. Corporate Tax Rate 28 

B. Dividends Received Deduction: Certain Dividends 

Received from a Foreign Sales Corporation 28 

C. Extraordinary Dividends Received by Corporate 

Shareholders 29 

D. Special Limitations On Net Operating Loss and 

Other Carryforwards 32 

1. Value of loss corporation: special rule in the 

case of redemption 32 

2. Definition of ownership charge: owner shift 
involving five-percent shareholder and 
equity structure change 32 

3. Special rules for built-in gains and losses 

and section 338 gains 33 

4. Testing period: shorter period where all 
losses arise after three-year period begins 34 

5. Definitions of loss corporation, old loss cor- 
poration, and new loss corporation 35 

6. Operating rules relating to ownership of 
stock 36 

7. Bankruptcy proceedings 37 

8. Effective dates 38 

E. Recognition of Gain or Loss on Liquidating Sales 

and Distributions of Property (General Utilities). 40 

1. Limitations on recognition of loss 40 

2. Election to treat certain stock sales and dis- 
tributions as asset transfers 41 

3. Treatment of distributing corporation where 
the 80-percent distributee is a tax-exempt 
organization , 42 

4. Basis adjustment in a taxable section 332 
liquidation 42 

5. Use of installment method by shareholders 

in certain liquidations 43 

6. Certain distributions of partnership or trust 
interests 43 



VII 

Page 

7. Losses on transactions between related par- 
ties 44 

8. Distributions of property to corporate share- 
holders 44 

9. Certain transfers to foreign corporations 45 

10. Gain from certain sales or exchanges of 
stock in certain foreign corporations 45 

11. Tax imposed on certain built-in gains on S 
corporations 47 

12. Regulatory authority to prevent circumven- 
tion of provisions 48 

13. Transition provisions 48 

a. Built-in gains of S corporations 48 

b. General transition rule based on pre- 

August 1, 1986 action 49 

c. Transitional rules for certain small corpo- 

rations 49 

d. Other transitional rules 52 

F. Allocation of Purchase Price in Certain Sales of 

G. Related Party Sales 53 

H. Amortizable Bond Premium 54 

I. Certain Entity Not Taxed as a Corporation 54 

J. Regulated Investment Companies 55 

K. Real Estate Investment Trusts 56 

L. Real Estate Mortgage Investment Conduits 57 

VII. Minimum Tax Provisions (Section 107 of the Bill) .. 61 

VIII. Accounting Provisions (Section 108 of the Bill) 64 

1. Limitation on the use of the cash method of 
accounting 64 

2. Capitalization rules foi" inventory, construc- 
tion, and development costs 66 

3. Long-term contracts 68 

4. Taxable years of certain entities 69 

5. Treatment of installment obligations 71 

6. Income attributable to utility services 73 

IX. Financial Institutions (Section 109 of the Bill) 74 

1. Limitations on bad debt reserves 74 

2. Interest on debt used to purchase or carry 
tax-exempt obligations 75 

X. Insurance Provisions (Sections 110 and 118(g) and 

(i) of the Bill) 78 

1. Treatment of certain market discount bonds. 78 

2. Status of certain organizations providing 
commercial-type insurance 78 

3. Inclusion in income of 20-percent of un- 
earned premium reserve 79 



VIII 

Page 

4. Treatment of certain dividends and tax- 
exempt interest 80 

5. Loss reserves 81 

6. Election to be taxed only on investment 
income 82 

7. Treatment of physicians' and surgeons' 
mutual protection associations 82 

8. Special rule for mutual life insurance com- 
pany 83 

9. Annuity diversification requirements 83 

10. Treatment of alternative minimum tax with 
respect to shareholder surplus account 84 

11. Treatment of certain items as not interest 

for source rules 84 

12. Technical corrections to the Deficit Reduc- 
tion Act of 1984 85 

XI. Pensions and Deferred Compensation; Employee 
Benefits; ESOPS (Secs. Ill, lllA, lllB, and 118(q) 
OF THE Bill) 86 

A. Limitations on Treatment of Tax-Favored Sav- 

ings 86 

1. Individual retirement arrangements (IRAs) .. 86 

2. Qualified cash or deferred arrangements 90 

3. Nondiscrimination requirements for employ- 
er matching contributions and employee 
contributions 95 

4. Unfunded deferred compensation arrange- 
ments of State and local governments and 
tax-exempt employers 98 

5. Deferred annuity contracts 100 

6. Elective contributions under tax-sheltered 
annuities 101 

7. Special rules for simplified employee pen- 
sions 102 

B. Nondiscrimination Requirements 105 

1. Minimum coverage requirements 105 

2. Minimum participation rule 105 

3. Vesting standards 109 

4. Application of nondiscrimination rules to in- 
tegrated plans 110 

5. Definitions of highly compensated employee 

and of line of business Ill 

6. Definition of compensation 114 

C. Treatment of Distributions 116 

1. Uniform minimum distribution rules 116 

2. Tax treatment of distributions 117 

3. Additional income tax on early withdrawals. 120 

4. Transition rule 125 

5. Loans from qualified plans 126 

D. Limits on Tax Deferral Under Qualified Plans 127 

1. Overall limits on contributions and benefits 

under qualified plans 127 



IX 

Page 

2. Deduction limits for qualified plans 130 

3. Excise tax on reversion of qualified plan 
assets to employer 132 

4. Excise tax on excess distributions from 
qualified retirement plans 134 

E. Miscellaneous Pension and Deferred Compensa- 

tion Provisions 139 

1. Discretionary contribution plans 139 

2. Time required for plan amendments 139 

3. Federal Thrift Savings Plan 140 

4. Effective dates for collectively bargained 
plans 140 

F. Employee Benefit Provisions 142 

1. Nondiscrimination rules for statutory em- 
ployee benefit plans 152 

2. Deductibility of health insurance costs of 
self-employed individuals 152 

3. Treatment of certain full-time life insurance 
salespersons 153 

4. Exclusion of cafeteria plan elective contribu- 
tions from wages for purposes of employ- 
ment taxes 153 

5. Tax treatment of qualified campus lodging ... 153 

6. Military fringe benefits 154 

G. Employee Stock Ownership Plans (ESOPs) 156 

1. Changes in qualification requirements relat- 
ing to ESOPs 156 

2. Estate tax deduction for sales to an ESOP 160 

3. Partial exclusion of interest earned on 
ESOP loans 161 

4. Sales of stock to an ESOP 163 

5. Dividends paid deduction 164 

H. Technical Corrections to the Retirement Equity 

Act of 1984 166 

XII. Foreign Tax Provisions (Section 112 of the Bill) .... 167 

A. Foreign Tax Credit 167 

1. Separate application of foreign tax credit 
provisions to financial services income 167 

2. Shipping income 170 

3. Transition rule for high withholding tax in- 
terest on qualified loans 170 

4. Passive income 171 

5. Separate application of foreign tax credit 
limitation under the look-through rules 172 

6. Definition of high withholding tax interest ... 174 

7. Deemed-paid credit 174 

8. Recapture of foreign separate limitation 
losses 175 

B. Source Rules 177 

1. Determination of source in case of sales of 

personal property 177 



X 

Page 

2. Special rules for exemption from U.S. tax on 

U.S. source transportation income 182 

3. Limitations on special treatment of 80/20 
corporations 183 

4. Rules for allocation of interest, etc., to for- 
eign source income 185 

C. U.S. Taxation of Income Earned Through Foreign 

Corporations 196 

1. Captive insurance companies 196 

2. Insurance companies in general 201 

3. Withdrawals of qualified shipping reinvest- 
ments that pre-Act law excluded from sub- 
part F income 202 

4. Definition of related person 203 

5. Measurement of earnings and profits 204 

6. Effective date of accumulated earnings tax 
amendments 206 

7. Dividends received deduction 206 

D. Special Tax Provisions for U.S. Persons 208 

1. Effective date of provision governing trans- 
fers of intangibles to related parties 208 

2. Treatment of certain passive foreign invest- 
ment companies 209 

E. Treatment of Foreign Taxpayers 217 

1. Branch profits tax 217 

2. Treatment of deferred payments and appre- 
ciation arising out of business conducted 
within the United States 221 

3. Withholding tax on amounts paid by part- 
nerships to foreign partners 222 

4. Income of foreign governments 225 

5. Dual residence companies 226 

F. Foreign Currency Exchange Rate Gains and 

Losses 227 

1. Foreign currency translation 227 

2. Foreign currency transactions 228 

G. Tax Treatment of Possessions 231 

H. Miscellaneous Foreign Provisions 233 

1. Relationship with treaties 233 

2. Foreign personal holding companies 236 

3. Withholding on pensions, annuities and cer- 
tain other deferred income 238 

4. Information exchange 238 

5. Maintaining the source of U.S. source 
income 239 

XIII. Tax-Exempt Bond Provisions (Section 113 of the 

Bill) 241 

1. Qualified small-issue bonds 241 

2. Student loan bonds 243 

3. Qualified 501(c)(3) bonds 243 

4. Mortgage revenue bonds and mortgage 
credit certificates 244 



XI 

Page 

5. Private activity bond volume limitation 244 

6. Public approval requirement for private ac- 
tivity bonds 245 

7. Limitation on bond-financing of issuance 
costs 245 

8. Arbitrage rebate requirement 246 

9 . Prohibition of Federal guarantees 249 

10. Change in use rules 249 

11. Bonds issued by volunteer fire departments.. 250 

12. Bonds issued under certain State programs... 250 

13. Effective dates 251 

14. Transitional exceptions 252 

XIV. Trusts and Estates; Minor Children; Generation- 
Skipping Transfer Tax (Section 114 of the Bill).. 257 

A. Income Taxation of Trusts and Estates 257 

1. Grantor treated as holding any power or 
interest of grantor's spouse 257 

2. Limitations to re visionary interest rule ex- 
ceptions 257 

3. Taxable year of trusts 258 

4. Estimated taxes of trusts and estates 258 

B. Taxation of Unearned Income of Minor Children .. 259 

C. Generation-Skipping Transfer Tax 261 

1. Overlap of direct skips and taxable termina- 
tion and distributions 261 

2. Treatment of charitable interests 261 

3. Special rule for determination of inclusion 
ratio where inter vivos transfers are includ- 
ible in transferor's gross estate 262 

4. Definition of skip person involving trusts 263 

5. Disregard of support obligations as an inter- 
est 264 

6. Taxation of multiple skips 264 

7. Certain interests disregarded 265 

8. Definition of transferor 265 

9. Regulatory authority to prescribe rules deal- 
ing with trust equivalents 266 

10. Clarification of inclusion ratio where all 
transfers to a generation-skipping trust 
qualify for the gift tax exclusions 266 

11. Generation assignment of governmental en- 
tities ■ 267 

12. Basis of property after a taxable termina- 
tion 267 

13. Treatment of single trust as multiple trusts.. 268 

14. Effective date of revised generation-skipping 
transfer tax 268 

15. $2 million exemption 269 



XII 

Page 

XV. Compliance and Tax Administration Provisions 

(Section 115 of the Bill) 271 

1. Nominee reporting by partnerships 271 

2. Negligence and fraud penalties 271 

3. Penalty for substantial understatement of 

tax liability 272 

4. Differential interest rate 272 

5. Information reporting by brokers 273 

6. Information reporting on persons receiving 
contracts from certain Federal agencies 273 

7. Information reporting on royalties 274 

8. Estimated tax requirements for tax-exempt 
organizations 275 

9. Awards of attorney's fees in tax cases 275 

10. Salary of special trial judges 275 

11. Retirement pay of Tax Court judges 275 

12. Suspension of statute of limitations during 
prolonged dispute over third-party records ... 277 

13. Rescission of statutory notice of deficiency.... 277 

14. General requirement of return, statement, 

or list 277 

15. Certain refundable credits to be assessed 
under deficiency procedures 278 

XVI. Exempt and Nonprofit Organizations (Section 116 

OF THE Bill) 279 

1. Title-holding companies 279 

XVII. Miscellaneous Provisions (Section 118 of the Bill) 282 

1. Tax-exempt entity leasing; definition of tax- 
exempt controlled entity 282 

2. Accrual of interest on certain short-term ob- 
ligations 282 

3. Earnings and profits 283 

4. Treatment of transferor corporation 283 

5. Golden parachutes 284 

6. Settlement funds 286 

7. Treatment of stripped tax-exempt bonds 287 

8. Reorganizations of investment companies 288 

9. Elimination of duplicative Medicare tax pro- 
visions for certain State and local govern- 
ment employees 288 

Title II. Technical Corrections to Other Tax Legislation 290 

A. The Superfund Revenue Act of 1986 290 

1. Tax on chemical feedstocks 290 

2. Broadbase environmental tax 291 

3. Leaking Underground Storage Tank Trust 
Fund 291 



XIII 

Page 

B. The Harbor Maintenance Act of 1986 293 

1. Tax rate for fuel used on inland waterways.... 293 

2. Exemption from the harbor maintenance tax 
for cargo transported between U.S. posses- 
sions, etc 293 

C. The Omnibus Budget Reconciliation Act of 

1986 295 

1. Exclusion of discharge of indebtedness 
income in determining tax-exempt status of 
mutual or cooperative telephone and elec- 
tric companies 295 

2. Payment period for excise taxes on imported 
beverages and tobacco products 296 



INTRODUCTION 

This pamphlet/ prepared by the staff of the Joint Committee on 
Taxation, provides a description of the provisions of H.R. 2636 and 
S. 1350 (The Technical Corrections Act of 1987), introduced on June 
10, 1987. H.R. 2636 was introduced by House Committee on Ways 
and Means Chairman Rostenkowski and Congressman Duncan; and 
S. 1350 was introduced by Senate Committee on Finance Chairman 
Bentsen and Senator Packwood. 

The bills are divided into two titles: Title I provides technical 
corrections to the Tax Reform Act of 1986 ("Reform Act") (P.L. 99- 
514); and Title II provides technical corrections to certain other tax 
legislation — the Superfund Revenue Act of 1986 ("Superfund Reve- 
nue Act") (P.L. 99-499), the Harbor Maintenance Revenue Act of 
1986 ("Harbor Revenue Act") (P.L. 99-662), and the Omnibus 
Budget Reconciliation Act of 1986 ("OBRA") (P.L. 99-509). Provi- 
sions in the bills for which no descriptions are provided are clerical 
in nature or are transition rules. 

The amendments made by the Technical Corrections Act of 1987 
are intended to correct, clarify, or conform various recently en- 
acted tax provisions. Provisions in the bills are generally effective 
as if included in the original legislation, unless otherwise indicated. 



' This pamphlet may be cited as follows: Joint Committee on Taxation, Description of the 
Technical Corrections Act of 1987 (H.R. 2636 and S. 1350) (JCS-15-87), June 15, 1987. 



(XV) 



TITLE I. TECHNICAL CORRECTIONS TO THE TAX REFORM 

ACT OF 1986 

I. Individual Income Tax Provisions (Sec. 101 of the Bill) 

1. Rate of tax with respect to certain unclaimed cash (sec. 

101(a)(1) of the bill, sec. 101 of the Reform Act, and sec. 6867 
of the Code) 

Present Law 

If the IRS determines that the assessment or collection of tax 
would be jeopardized by delay, the IRS may use expedited proce- 
dures as specified in the Internal Revenue Code (sees. 6851 and 
6861). For purposes of these expedited assessment and collection 
procedures, special rules apply if an individual who is in possession 
of cash (or cash equivalents) in excess of $10,000 does not claim the 
cash either as his or as belonging to another identifiable person 
who acknowledges ownership (sec. 6867). 

These rules provide that the cash is presumed to represent gross 
income of a single individual and that the collection of tax will be 
jeopardized by delay. Under present law, such income is taxable to 
the possessor of the unclaimed cash at a 50-percent rate (sec. 
6867(b)), i.e., the highest income tax rate imposed by Code section 1 
as in effect immediately prior to the rate reductions made by the 
Act. 

Explanation of Provision 

The bill provides that the rate of tax applicable with respect to 
unclaimed amounts of cash described in section 6867 is the highest 
income tax rate specified in Code section 1. This rate is 38.5 per- 
cent for taxable years beginning in 1987 and 28 percent for subse- 
quent years. 

2. Rate of accumulated earnings tax (sec. 101(a)(2) of the bill, sec. 

101 of the Reform Act, and sec. 531 of the Code) 

Present Law 

The Act generally reduces the maximum rate of Federal income 
tax on individuals to 28 percent, effective for taxable years begin- 
ning after 1987. As a conforming amendment, the personal holding 
company tax rate (sec. 541) also is reduced to 28 percent for taxable 
years beginning after 1987. However, the Act did not reduce the ac- 
cumulated earnings tax rate (sec. 531), notwithstanding that each 
of these additional corporate taxes is imposed to prevent taxpayers 
from using a corporation to avoid income tax on the corporation's 
shareholders. 

(1) 



Explanation of Provision 

The bill provides that the rate of the accumulated earnings tax 
will be 28 percent, effective for taxable years of the corporation be- 
ginning after December 31, 1987. This amendment shall not be 
treated as a change in tax rates for purposes of Code section 15. 

3. Standard deduction and filing requirement for elderly or blind 
dependents (sec. 101(b) of the bill, sec. 102 of the Reform Act, 
and sees. 63(c)(5) and 6012(a) of the Code) 

Present Law 

The Act provides a standard deduction for individuals who do not 
itemize. Elderly or blind taxpayers who do not itemize are allowed 
an additional standard deduction amount above the basic standard 
deduction allowed to all nonitemizers. 

The additional standard deduction amount is $600 for an elderly 
or blind individual who is married (whether filing jointly or sepa- 
rately) or is a surviving spouse; the additional amount is $1,200 for 
such an individual who is both elderly and blind. An additional 
standard deduction amount of $750 is allowed for a head of house- 
hold who is elderly or blind ($1,500, if both), or for a single individ- 
ual (i.e., an unmarried individual other than a surviving spouse or 
head of household) who is elderly or blind ($1,500, if both). Thus, 
for example, in 1987 a single elderly individual may claim a basic 
standard deduction of $3,000 plus an additional standard deduction 
of $750, for a total of $3,750. 

Under the Act, the standard deduction for an individual who 
may be claimed as a dependent on another taxpayer's return is 
limited to the greater of $500 or the amount of the individual's 
earned income (Code sec. 63(c)(5)). The filing threshold for such an 
individual is the amount of standard deduction that is allowable 
(sec. 6012(a)(1)(C)). 

Explanation of Provision 

The bill modifies the standard deduction limitation imposed 
under section 63(c)(5) on a taxpayer who may be claimed as a de- 
pendent on the return of another taxpayer to apply only with re- 
spect to the basic standard deduction; thus, the limitation does not 
also apply with respect to the additional standard deduction 
amount allowed to elderly or blind individuals. 

Accordingly, an elderly or blind individual who may be claimed 
as a dependent on another taxpayer's return may claim a basic 
standard deduction up to the greater of $500 or the amount of 
earned income, plus the additional standard deduction amount 
(e.g., $600 for a married taxpayer). Since this additional standard 
deduction amount is not limited by the amount of the dependent's 
earned income, it may be applied against any remaining income 
(earned or unearned) that has not been offset by the allowance of 
the basic standard deduction as described above. 

Section 6012(a)(l)(C)(i), which relates to the filing threshold for 
certain individual taxpayers, is amended to conform to the modifi- 
cation to section 63(c)(5). Thus, for example, an unmarried elderly 



individual who may be claimed as a dependent on her daughter's 
tax return must file a return for 1987 only if the elderly individual 
either (1) has total gross income exceeding $3,750 or (2) has non- 
earned income exceeding $1,250. 

4. Rule for inflation adjustments to earned income credit (sec. 

101(c) of the bill, sec. Ill of the Reform Act, and sec. 32(1) of 
the Code) 

Present Law 

The Act modifies the earned income credit to provide for infla- 
tion adjustments. An inflation adjustment to the earned income 
credit is rounded to the nearest multiple of $10 (sec. 32(i)(3)). 

Explanation of Provision 

Under the bill, the provision relating to rounding of inflation ad- 
justments to the earned income credit applies to the sum of the 
earned income credit amount (prior to adjustment) plus the infla- 
tion adjustment, rather than to the inflation adjustment amount 
itself. Thus, the statute provides that the dollar amount of the 
earned income credit after being increased by the inflation adjust- 
ment is rounded to the nearest multiple of $10. 

5. Cross-references to scholarship exclusion provisions in private 

foundation rules (sec. 101(d)(1) of the bill, sec. 123 of the 
Reform Act, and sees. 4945(g)(1) and 4941(d)(2)(G) of the 
Code) 

Present Law 

Code section 4945(g)(1) provides that certain scholarship or fel- 
lowship grants that are made by private foundations do not consti- 
tute taxable expenditures if the grant "is subject to the provisions 
of section 117(a)." Section 4941(d)(2)(G) provides that certain schol- 
arship or fellowship grants that are made by private foundations to 
government officials do not constitute acts of self-dealing if the 
grants "are subject to the provisions of section 117(a)." The Act 
limits the section 117(a) exclusion for certain scholarship and fel- 
lowship grants made to degree candidates to amounts not exceed- 
ing the recipient's tuition and course-related expenses, and repeals 
the prior-law limited exclusion for nondegree candidates. 

Explanation of Provision 

The bill amends the cross-references in the private foundation 
provisions cited above to refer to certain scholarship or fellowship 
grants that would be subject to the provisions of Code section 117(a) 
as in effect prior to its amendment by the Act. Accordingly, the 
amendments made by the Act to the section 117(a) exclusion do not 
treat scholarship or fellowship grants made by a private foundation 
that would not have triggered section 4945 or 4941 excise taxes 
under prior law as taxable expenditures or self-dealing acts merely 
because such grants exceed the amount excludable by degree candi- 
dates under section 117 as amended by the Act or merely because 



such grants (up to the amount excludable under prior law) are 
made to nondegree candidates. 

6. Treatment of certain scholarship or fellowship grants to non- 
resident aliens (sec. 101(d)(2) of the bill, sec. 123 of the Reform 
Act, and sees. 1441(b) and 871(c) of the Code) 

Present Law 

Under present and prior law, Code section 1441(b) provides for a 
14-percent withholding rate on amounts received by a nonresident 
alien who is temporarily present in the United States under an 
"F" or "J" visa that are "incident to a qualified scholarship to 
which section 117(a) applies, but only to the extent such amounts 
are includible in gross income." Under section 871(c), such amounts 
are subject to U.S. tax on a net income basis. 

Under prior law, a nondegree candidate could exclude from gross 
income under section 117 a limited amount of a scholarship or fel- 
lowship granted by an educational institution or other tax-exempt 
organization described in section 501(c)(3), a foreign government, 
certain international organizations, or a Federal, State, or local 
government agency. The prior-law exclusion for a nondegree candi- 
date in any one year could not exceed $300 times the number of 
months in the year for which the recipient received scholarship or 
fellowship grant amounts, and no further exclusion was allowed 
after the nondegree candidate had claimed exclusions for a total of 
36 months (i.e., a maximum lifetime exclusion of $10,800). However, 
this dollar limitation did not apply to that portion of the scholar- 
ship or fellowship received by the nondegree candidate for travel, 
research, clerical help, or equipment. 

The Act repeals the limited prior-law exclusion under section 117 
for grants received by nondegree candidates. As a result, scholar- 
ship or fellowship grants received by nonresident aliens who are 
nondegree candidates are subject to withholding at a 30-percent 
rate, and to U.S. tax on a gross income basis, since no amount of 
such grants is "incident to a qualified scholarship to which section 
117(a) applies." 

The Act also provides that in the case of a scholarship or fellow- 
ship grant received by a degree candidate, an exclusion under sec- 
tion 117 is available only to the extent the individual establishes, 
in accordance with the conditions of the grant, that the grant was 
used for (1) tuition and fees required for enrollment or attendance 
of the student at an educational institution (within the meaning of 
sec. 170(b)(l)(A)(ii)), and (2) fees, books, supplies, and equipment re- 
quired for courses of instruction at the educational institution. 

Explanation of Provision 

The bill provides that withholding at a 14-percent rate applies to 
amounts received as a scholarship or fellowship for study, training, 
or research at an educational institution (described in sec. 
170(b)(l)(A(ii)) in the United States by a nonresident alien who is 
not a degree candidate, if the grant is made by the educational in- 
stitution or any other tax-exempt organization described in section 
501(c)(3), a foreign government, certain international organizations. 



or a Federal, State, or local government agency. Also, such 
amounts eligible for the 14-percent withholding rate are subject to 
U.S. tax on a net income basis under section 871(c). 

As under present law, withholding at 14 percent and taxation on 
a net income basis apply to amounts received by a nonresident 
alien who is a degree candidate that are incident to a qualified 
scholarship or fellowship to which section 117(a) applies, but only 
to the extent includible in gross income (e.g., amounts received for 
room, board, or travel). 

The bill applies the above rules to "M" visa holders as well as 
"F" and "J" visa holders. 1 

7. Coordination of two-percent floor and certain other deduction 
limitation provisions (sec. 101(f)(1) of the bill, sec. 132 of the 
Reform Act, and sec. 67 of the Code) 

Present Law 

Code section 67 provides that miscellaneous itemized deductions 
(generally, certain unreimbursed employee business expenses and 
certain items allowable under sec. 212) are deductible by itemizers 
only to the extent that, in the aggregate, they exceed two percent 
of the taxpayer's adjusted gross income (AGI). Other limitations 
also apply to particular items that constitute miscellaneous item- 
ized deductions. For example, the last sentence of section 162(a) 
limits certain deductions for away-from-home living expenses in- 
curred by Members of Congress to $3,000 per year. 

Explanation of Provision 

The bill clarifies that the two-percent floor on miscellaneous 
itemized deductions applies prior to application of the $3,000 limi- 
tation on certain deductions for Members' away-from-home living 
expenses. Thus, for example, a Member with AGI of $100,000 who 
has $5,000 of away-from-home living expense deductions described 
in section 162(a) (disregarding the dollar limitation contained 
therein) would be allowed such deductions in the amount of 
$3,000.2 

This clarification is consistent with the general rule under the 
Act to apply certain deduction limitation provisions in the follow- 
ing order: first, provisions disallowing a percentage of a deduction 
(e.g., sec. 274(n), generally limiting meal and entertainment deduc- 
tions to 80 percent of the amount otherwise allowable); second, pro- 



' Similar amendments relating to "M" visa holders are made to Code sees. 3121(b)(19), 3231(e), 
3306(cK19), and 7701(b)(5)(D), and sec. 210(a)(19) of the Social Security Act. 

2 In addition, if a Member has expenses subject to the $3,000 limitation and other miscellane- 
ous itemized deductions, the amounts disallowed by the two-percent floor are disallowed propor- 
tionately. For example, assume that a Member with AGI of $100,000 has $5,000 of away-from- 
home expenses (qualifying for the deduction, disregarding application of the $3,000 limit and the 
two-percent floor, but after application of the 80-percent rule for meal and entertainment ex- 
penses) and $5,000 of other miscellaneous itemized deductions, for a total of $10,000 of potential 
deductions subject to the two-percent floor. Application of the two-percent floor would limit 
these deductions to $8,000, and the amount disallowed because of the two-percent floor would be 
disallowed proportionately. Thus, after application of the two-percent floor, the Member could 
deduct $4,000 of the away-from-home expenses and $4,000 of the miscellaneous itemized deduc- 
tions. The former amount (i.e., the away-from-home expenses) is further limited to $3,000 be- 
cause of the special limitation on deducting Members's expenses in sec. 162(a). Thus, the 
Member could deduct a total of $7,000 of miscellaneous itemized deductions. 



6 

visions disallowing a fixed dollar amount of certain deductions (e.g., 
the two-percent floor on miscellaneous itemized deductions); and 
third, provisions establishing a deduction ceiling (e.g., the $3,000 
limit in the last sentence of sec. 162(a), and certain dollar limita- 
tions in sec. 217 on deductions for moving expenses). 

8. Application of two-percent floor to trusts and estates (sees. 
101(f)(2), (3), and (4) of the bill, sec. 132 of the Reform Act, and 
sec. 67 of the Code) 

Present Law 

Under the Act, miscellaneous itemized deductions (generally, cer- 
tain unreimbursed employee business expenses and items deducti- 
ble under sec. 212) are deductible only to the extent that, in the 
aggregate, they exceed two percent of the taxpayer's adjusted gross 
income (Code sec. 67). In listing the itemized deductions that are 
not subject to the new two-percent floor, the Act specifically in- 
cludes the deduction under section 170 (for charitable contributions 
by individuals or corporations), but does not include the deduction 
for estates and trusts under section 642(c) (relating to items paid or 
permanently set aside for a charitable purpose). 

Section 67(e) provides that, for purposes of section 67, the adjust- 
ed gross income of an estate or trust is computed in the same 
manner as for an individual, except that certain costs paid in con- 
nection with the administration of the estate or trust are treated 
as allowable in arriving at adjusted gross income. The provision 
does not state the treatment, for purposes of section 67, of deduc- 
tions under sections 651 and 661 (relating to certain amounts dis- 
tributed by a trust or estate). 

Section 67(c) provides that Treasury regulations are to (1) prohib- 
it the indirect deduction through pass-through entities of amounts 
that are not allowable as a deduction if paid or incurred directly by 
an individual, and (2) contain such reporting requirements as are 
necessary to accomplish this object. Such regulatory authority does 
not, however, apply with respect to estates, trusts, cooperatives, 
and REITs (real estate investment trusts). 

Explanation of Provision 

The bill provides that deductions under section 642(c) are not 
miscellaneous itemized deductions subject to the new two-percent 
floor. 

In addition, the bill provides that the distribution deductions al- 
lowable to an estate or trust under sections 651 and 661 are treated 
as allowable in computing the adjusted gross income of the estate 
or trust. Similarly, deductions for costs paid or incurred in connec- 
tion with the administration of an estate or trust, and which would 
not have been incurred if the property were not held in such trust 
or estate, are treated as allowable in computing the adjusted gross 
income of the estate or trust. Thus, deductions under sections 651 
and 661, and such administrative costs of an estate or trust, are not 
limited under the new two-percent floor, and are treated as allow- 
able in arriving at the adjusted gross income of the trust or estate 
for purposes of section 67. 



The bill modifies section 67(c) to provide that the regulatory au- 
thority of the Treasury with regard to indirect deductions through 
pass-through entities shall not, except as provided in regulations, 
apply to estates and trusts. Under this provision, the Treasury has 
regulatory authority (for example) to apply the two-percent floor at 
the beneficiary level, rather than at the entity level, to the extent 
that income is distributed to beneficiaries. As under the Act, the 
Treasury's regulatory authority does not apply with respect to co- 
operatives and REITs. 

9. Clarification of exceptions to certain rules limiting meal and 
entertainment deductions (sec. 101(g) of the bill, sec. 142 of the 
Reform Act, and sees. 274(k)(2), 274(m)(l), and 274(n)(2) of the 
Code) 

Present Law 

Code section 274(k) denies deductions for the expense of any food 
or beverages unless such expense is not lavish or extravagant 
under the circumstances, and unless the taxpayer or an employee 
of the taxpayer (including, for this purpose, certain independent 
contractors) is present at the furnishing of such food and bever- 
ages. Code section 274(n) generally limits the amount otherwise al- 
lowable as a deduction for the expense of any food or beverages, or 
any entertainment expense, to 80 percent of the amount otherwise 
allowable. Special limitations apply under section 274(m)(l) to de- 
ductions for luxury water transportation. However, the above limi- 
tations under the Act do not apply to items that are not treated as 
entertainment expenses for purposes of section 274(a) by reason of 
certain of the exceptions listed in section 274(e). 

Explanation of Provision 

The bill clarifies that the exceptions to sections 274(k)(2), 
274(m)(l), and 274(n)(2) described by cross-references to certain 
paragraphs of section 274(e) are not subject to the limitations of 
sections 274(k)(2), 274(m)(l), or section 274(n)(2), whether or not 
such items (disregarding sec. 274(e)) would be treated as entertain- 
ment expenses for purposes of section 274(a). 

The bill also provides that the Treasury has regulatory authority 
to provide additional exceptions to the taxpayer-presence require- 
ment in section 274(k)(2). For example, an exception could be pro- 
vided for meal expenses of the taxpayer's spouse and children in- 
curred by them as moving expenses deductible pursuant to section 
217, even though the taxpayer travelled separately to the new job 
location. As a further example, the taxpayer-presence requirement 
could be waived by Treasury regulations in the situation where a 
business reimburses away-from-home meal expenses of a job appli- 
cant who travels to the business location the night before his or 
her job interview and has a meal alone in the hotel where he or 
she is staying. 



10. Carryover of excess home office deductions (sec. 101(h) of the 
bill, sec. 143 of the Reform Act, and sec. 280A(c)(5) of the 
Code) 

Present Law 

Section 280A limits certain deductions with respect to business 
use of a dwelling unit that is used by the taxpayer during the tax- 
able year as a residence. In general, such deductions, if not wholly 
disallowed, are limited to the amount of certain income from the 
business in which they arose. Under the Act, deductions that are 
disallowed by reason of exceeding the amount of such business 
income may be taken into account as a deduction (allocable to such 
business use of the dwelling unit) for the succeeding taxable year 
(sec. 280A(c)(5)). 

Explanation of Provision 

The bill clarifies that, when a deduction for business use of a 
dwelling unit is carried forward to a succeeding taxable year by 
reason of the business income limitation in section 280A(5), such 
deduction shall continue to be allowable only up to the amount of 
income from the business in which it arose, whether or not the 
dwelling unit is used as a residence during such taxable year. 



II. Capital Cost Provisions (Sec. 102 of the Bill) 
A. Depreciation and Regular Investment Tax Credit 
1. Depreciation provisions 

a. Effect of depreciation on earnings and profits of foreign 

corporations (sec, 102(a)(3) of the bill, sec. 201(b) of the 
Reform Act, and sec. 312(k)(4) of the Code) 

Present Law 

The Act prescribes an alternative depreciation system to com- 
pute the earnings and profits of a corporation. 

Explanation of Provision 

The bill clarifies that the alternative depreciation system applies 
to compute the earnings and profits of all foreign corporations. 

b. Certain property placed in service in churning transac- 

tions (sec. 102(a)(6) of the bill, sec. 201(a) of the 
Reform Act and sec. 168(f)(5) of the Code) 

Present Law 

The Act prescribes rules to prevent taxpayers from bringing cer- 
tain property placed in service after December 31, 1980, under the 
modified Accelerated Cost Recovery System ("ACRS"), where the 
result would be to qualify such property for more generous depre- 
ciation. 

Explanation of Provision 

The bill clarifies that the determination of whether property 
would qualify for more generous depreciation is made by compar- 
ing depreciation deductions for the first taxable year (whether a 
short year or a full year), assuming a half-year convention. 

Further, the anti-churning rule is inapplicable to property to 
which the modified ACRS applied in the hands of the transferor. 

Finally, with respect to property that is subject to the anti-churn- 
ing rule, the transferee is subject to the same depreciation regime 
that the transferor used. Thus, for property that was placed in 
service by the transferor before January 1, 1981, the transferee 
would use pre-1981 depreciation rules. Similarly, for property that 
was subject to ACRS O^efore amendment by the Act) in the hands 
of the transferor, the transferee would use pre-1987 ACRS. 



(9) 



10 

c. Treatment of certain transferees (sec. 102(a)(7) of the 

bill, sec. 201(a) of the Reform Act, and sec. 168(i)(7) of 
the Code) 

Present Law 

In certain cases, the transferee of property is treated as the 
transferor for purposes of computing depreciation deductions with 
respect to so much of the basis in the hands of the transferee as 
does not exceed the adjusted basis in the hands of the transferor. 

Explanation of Provision 

The bill clarifies that in any case where ACRS, as in effect before 
enactment of the Act, applied to property in the hands of the trans- 
feror, the transferee will use pre-enactment ACRS for purposes of 
computing depreciation deductions. 

The bill clarifies that the "step in the shoes" rule applies to 
transactions between members of an affiliated group of corpora- 
tions filing a consolidated return. In addition, the Act was not in- 
tended to apply to a mere change in form of ownership not involv- 
ing a sale or exchange. For example, the change from ownership as 
tenants-in-common to condominium ownership not involving per- 
centage ownership would not require the owners to begin depreci- 
ating the property over a new period. 

The bill deletes the exception for transactions to which the anti- 
churning rule applies. 

d. Exception for certain property subject to U.S. tax and 

used by foreign persons (sec. 102(a)(8) of the bill, sec. 
201(a) of the Reform Act, and sec. 168(h)(2)(b) of the 
Code) 

Present Law 

The Act provides that modified ACRS is inapplicable to motion 
picture films, video tapes, and sound recordings. The tax-exempt 
entity leasing rules contain an exception for foreign persons with 
respect to this property. 

Explanation of Provision 

The bill deletes the tax-exempt entity leasing exception for 
motion picture films, video tapes, and sound recordings. The bill 
also repeals related rules that applied for purposes of the invest- 
ment tax credit. 

e. Applicable depreciation method (sec. 102(a)(ll) of the 

bill, sec. 201(a) of the Reform Act, and sees. 168(b) and 
(c) of the Code) 

Present Law 

The Act permits taxpayers to elect to apply the alternative de- 
preciation system to any class of property for any taxable year. 
Generally, the alternative depreciation system requires use of the 
straight-line method over a recovery period equal to property's 



11 

present class life. For purposes of the depreciation preference 
under the minimum tax, the cost of property generally is recovered 
using the 150-percent declining balance method over the present 
class life. 

Explanation of Provision 

The bill permits taxpayers to elect to apply the minimum tax de- 
preciation rule — 150-percent over present class life — for purposes of 
the regular tax. 

f. Election to expense certain depreciable business assets 

(sec. 102(b)(1) of the bill, sec. 201(d) of the Reform Act, 
and sec. 179 of the Code) 

Present Law 

The Act modified the provision under which a taxpayer can elect 
to treat the cost of qualifying property as an expense that is not 
chargeable to capital account. The costs for which the election is 
made are allowed as a deduction for the taxable year in which the 
qualifying property is placed in service, subject to a $10,000 limita- 
tion each year ($5,000 for a married individual filing a separate 
return). The amount eligible to be expensed is limited for any tax- 
able year in which the aggregate cost of qualifying property placed 
in service exceeds $200,000; for every dollar of investment in excess 
of $200,000, the $10,000 ceiling is reduced by $1. In addition, the 
amount eligible to be expensed is limited to the taxable income de- 
rived from active trades or businesses. Costs that are disallowed be- 
cause of the limitation based on taxable income are carried for- 
ward to the succeeding taxable year. 

Explanation of Provision 

The bill clarifies that costs that are disallowed because of the 
limitation based on taxable income can be carried forward to an 
unlimited number of years. Also, the deduction of costs that are 
carried forward is limited by the $10,000 ceiling (subject to any re- 
duction due to investments that exceed $200,000) in every taxable 
year. 

g. Effective dates; transitional rules (sees. 102(c) and (d) of 

the bill and sees. 203 and 204 of the Reform Act) 

Present Law 

The Act modified ACRS for property placed in service after De- 
cember 31, 1986. The Act provided an election to apply modified 
ACRS to certain property placed in service after July 31, 1986. 
Such an election disqualified property under the investment tax 
credit transitional rules — discussed below. The Act provides certain 
exceptions to the general effective date. 

Explanation of Provisions 

The bill clarifies that the election to apply modified ACRS to 
property placed in service after July 31, 1986, is unavailable to 



12 

property that would be subject to the anti-churning rule if such 
property were placed in service after December 31, 1986. Also, 
property that would be subject to modified ACRS — but for the ap- 
plication of the effective date or a transitional rule — is taken into 
account for purposes of determining whether property covered by 
an election to apply modified ACRS will be subject to the mid-quar- 
ter convention. 

The bill also clarifies that modified ACRS applies to any real 
property that was acquired before January 1,1987, and converted 
from personal use on or after such date to a use for which deprecia- 
tion is allowable. 

For purposes of the general transitional rules, all members of the 
same affiliated group of corporations (within the meaning of sec- 
tion 1504 of the Code) filing a consolidated return are treated as 
one taxpayer. 

The bill makes other clarifying amendments to transitional rules 
of more limited application, including — but not limited to — clarifi- 
cations that (1) the general rule for property financed with tax- 
exempt bonds does not override more specific transitional rules, 
and (2) the rule for finance leases of farm equipment incorporates 
the amendments made by the Tax Reform Act of 1984. 

Section 204(a)(5)(T) of the Act was intended to include a third 
project, the approximate cost of which is $375 million, of which ap- 
proximately $260 million was spent on off-site construction. As the 
result of a clerical error, the introduced bills did not include this 
amendment. 

2. Investment tax credit 

a. Termination of regular percentage (sec. 102(e) of the bill, 
sec. 211 of the Reform Act, and sec. 49 of the Code) 

Present Law 

For purposes of determining the amount of the investment tax 
credit C'lTC"), the regular percentage does not apply to property 
placed in service after December 31, 1985, subject to an exception 
for transition property. A taxpayer is required to reduce the basis 
of property that qualifies for transition relief ("transition proper- 
ty") by the full amount of ITC earned. Further, the ITCs allowable 
for transition property for taxable years beginning after June 30, 
1987, and carryforwards to the first taxable year beginning after 
June 30, 1987, is reduced by 35 percent. For taxpayers with a tax- 
able year that straddles July 1, 1987, ITCs are subject to a partial 
reduction that reflects the appropriate reduction for the portion of 
the taxable year after that date. ^ In the case of transition property 
that was subject to a full basis adjustment in respect of ITCs 
earned but unused, there is no upward basis adjustment if the ITCs 
are subject to further reduction when carried forward. 



' In the case of a corporation that is included in a consoHdated return, the determination of 
whether the taxable year straddles July 1, 1987, is to be made by reference to the taxable year 
of the consolidated group, and not by reference to any short taxable year applicable to a corpo- 
ratien that is sold out of the group or a corporation that joins the group. 



13 

Explanation of Provision 

The bill clarifies that a full basis adjustment is applied only with 
respect to the portion of an ITC attributable to the regular percent- 
age. Further, if a credit for which a full basis adjustment was re- 
quired (1) is recaptured, there will be an upward basis adjustment 
of 100 percent of the recapture amount, or (2) expires at the end of 
the carryforward period, a deduction will be allowed for 100 per- 
cent of the unused credit. Also, in applying the rule that coordi- 
nates the election to pass an ITC to a lessee and the basis adjust- 
ment, the required income inclusion is equal to 100 percent of the 
credit allowed to the lessee. 

The bill also clarifies that the 35-percent reduction applies to ITC 
carryforwards used in a taxable year ending after June 30, 1987, 
irrespective of when the property with respect to which the credit 
is claimed was placed in service. For taxable years that straddle 
July 1, 1987, the bill clarifies that the amount added to carryfor- 
wards bears the same ratio to the carryforwards from the taxable 
year (before inclusion of the additional amount) as the reduction of 
the credit bears to the sum of the current year credit for the tax- 
able year and the carrjrforwards to the taxable year, less the reduc- 
tion of the credit under section 49(c)(3). 

The bill also makes clarifying amendments to other transition 
rules of more limited application. 

b. Elective 15-year carryback for steel companies and quali- 
fied farmers (sec. 102(f) of the bill and sees. 212 and 
213 of the Reform Act) 

Present Law 

Certain steel companies can elect a 15-year carryback of 50 per- 
cent of ITC carryforwards in existence as of the beginning of a tax- 
payer's first taxable year beginning after December 31, 1985. 

The amount claimed as a payment against the tax for the first 
taxable year beginning on or after January 1, 1987 cannot exceed 
the taxpayer's net tax liability for all taxable years during the car- 
ryback period (not including minimum tax liability, and reduced by 
the sum of certain allowable credits). In the case of an electing cor- 
poration that is a member of an affiliated group of corporations 
that filed a consolidated tax return during any portion of the carry- 
back period, the Act contemplates that the Internal Revenue Serv- 
ice will reduce the administrative burden of complying with this 
requirement — for example, by permitting the use of pro forma 
statements. 

Explanation of Provisions 

The bill provides that rules similar to the rules of section 6425 
shall apply to any overpayment resulting from the application of 
the provision for the elective 15-year carryback. Other conforming 
and technical changes are made. 



14 

B. Rapid Amortization Provisions 

1. Trademark and trade name expenditures (sec. 102(i) of the bill, 

sec. 241 of the Reform Act, and sec. 167 of the Code) 

Present Law 

The Act repealed the prior law provision that allowed taxpayers 
to elect to amortize over a period of at least 60 months expendi- 
tures for the acquisition, protection, expansion, registration or de- 
fense of a trademark or trade name other than an expenditure 
which was part of the consideration for an existing trademark or 
tradename. 

No amortization or depreciation deduction is intended to be al- 
lowed for trademark or trade name expenditures. 

Explanation of Provision 

The bill clarifies that no depreciation or amortization deduction 
is allowable for trademark or trade name expenditures. 

2. Railroad grading or tunnel bores (sec. 102(i) of the bill, sec. 242 

of the Reform Act, and sec. 167 of the Code) 

Present Law 

The Act repealed the prior law provision which provided an elec- 
tion to amortize the cost of qualified railroad grading and tunnel 
bores over a 50 year period. 

No amortization or depreciation deduction is intended to be al- 
lowed for such expenditures. 

Explanation of Provision 

The bill clarifies that no amortization or depreciation deduction 
is allowable with respect to railroad grading or tunnel bores. 

C. Real Estate Provisions 

1. Tax credit for rehabilitation expenditures (sec. 102(k) of the bill 
and sec. 251 of the Reform Act) 

Present Law 

The Act modified the rehabilitation credit generally for property 
placed in service after December 31, 1986. Exceptions were provid- 
ed under transitional rules. 

Explanation of Provisions 

The bill clarifies that a rehabilitation need not be completed pur- 
suant to a written contract that was binding on March 1, 1986, 
under the transitional rule that applies where property was ac- 
quired before March 2, 1986, or after that date pursuant to a writ- 
ten binding contract, and either required parts of the Historic Pres- 
ervation Certification Application were filed, or the lesser of $1 
million or five percent of the qualified rehabilitation expenditures 
were incurred or required to be incurred before that date. 



15 

Under a provision included in the capital cost recovery section 
(discussed above), the bill clarifies that property eligible for a 25- 
percent credit under a transitional rule is not subject to the full 
basis adjustment requirement. 

The bill also includes amendments with respect to other transi- 
tional rules of more limited application. 

2. Tax credit for low-income rental housing (sec. 102(1) of the bill, 
sec. 252 of the Reform Act, and sec. 42 of the Code) 

Present Law 

The Act provides a tax credit that may be claimed by owners of 
residential rental property used for low-income housing. The credit 
is claimed annually, generally for a period of ten years beginning 
either with the year a building is placed in service or one year 
thereafter (the credit period). Special rules apply to multiple build- 
ing projects and for certain subsequent additions to basis. 

New construction and rehabilitation expenditures for low-income 
housing projects placed in service in 1987 are eligible for a maxi- 
mum nine percent credit, claimed annually for ten years. The ac- 
quisition cost of existing buildings and the cost of newly construct- 
ed buildings receiving other Federal subsidies (e.g., tax-exempt 
bond financing) placed in service in 1987 are eligible for a maxi- 
mum four percent credit, also claimed annually for ten years. For 
buildings placed in service after 1987, these credit percentages will 
be adjusted to maintain a present value of 70 percent and 30 per- 
cent for the two types of credits, and will be determined monthly 
for property placed in service in each month. 

To qualify, a low-income housing project must satisfy a low- 
income set-aside requirement of either (1) 20 percent of the units 
occupied by persons having incomes of 50 percent or less of area 
median income, or (2) 40 percent of the units occupied by persons 
having incomes of 60 percent or less of such area income. A special 
additional requirement applies to projects satisfying a specified 
rent-skewing requirement. 

The credit amount is based on the qualified basis of the housing 
units serving the low-income tenants. Qualified basis is the portion 
of the basis of the building (eligible basis) attributable to low- 
income housing units. Basis of units whose cost is disproportionate 
to that of the low-income housing units is excluded from eligible 
basis. 

Rents that may be charged families in units on which a credit is 
claimed may not exceed 30 percent of the applicable income quali- 
fying as "low", adjusted for family size. Section 8 payments are ex- 
cluded in determining the amount of rent a tenant pays for pur- 
poses of this 30-percent limit. 

To qualify for the credit, residential rental property must comply 
continuously with all requirements of the credit throughout a 15- 
year compliance period, ^ and, in the case of a credit for acquisition, 



^ Failure to satisfy this 15-year compliance period results in recapture of a portion of the 
credit. (A special rule for determining a disposition is a recapture event applies to projects 
owned by certain large partnerships.) 



16 

may not have previously been placed in service for at least 10 years 
(the 10-year rule). A credit allocation from the appropriate State 
credit authority must be received by the owner of property eligible 
for the low-income housing tax credit, unless the property is sub- 
stantially financed with the proceeds of tax-exempt bonds subject 
to the new private activity bond volume limitation. Allocations are 
charged against the issuer's credit authority for the year of the al- 
location. Carryforwards of unused credit authority are not permit- 
ted. 

Explanation of Provisions 
Election to determine credit percentage early 

The bill provides that, in addition to the method of determining 
the credit percentage under present law, for buildings placed in 
service by a taxpayer after 1987 the taxpayer (with the consent of 
the housing credit agency) may irrevocably elect to determine the 
credit percentage applicable to the building in advance of the build- 
ing's placed-in-service date. Such an election will be binding for 
Federal income tax purposes on the taxpayer, the credit agency, 
and all successors in interest. The election must be made at the 
time a binding commitment is received by the taxpayer from the 
credit agency as to the housing credit dollar amount to be allocated 
to the building. In the case of a building financed with the proceeds 
of tax-exempt bonds for which no allocation from a credit agency is 
required, the election must be made by the taxpayer at the time 
the tax-exempt bonds are issued. The election must be filed with 
the Treasury Department by the fifth day of the month following 
the date the binding commitment is made or the bonds are issued. 
This election is applicable to credits attributable to new construc- 
tion, rehabilitation, and acquisition expenditures. 

Determination of gross rent 

The bill provides that in determining the gross rent that may be 
paid by a tenant in a low-income unit, payments of State and local 
rental assistance programs comparable to section 8 of the United 
States Housing Act of 1937 are not considered. The bill further pro- 
vides that this definition of gross rent is used for purposes of deter- 
mining the rent that may be charged to a low-income tenant when 
applying the elective deep-rent skewing set-aside requirement for 
certain projects {see sec. 142(d)(4)). (The bill retains the definition of 
gross rent, which includes all rental assistance payments, used in 
the deter minination of the 3:1 rent skewing test also provided for 
those projects.) 

The bill further provides that if a Federal rental assistance pay- 
ment is made with respect to a low-income unit and the Federal 
statute (as in effect on October 22, 1986) governing that assistance 
payment requires that the gross rent paid by the occupants for that 
unit increase as the income of the occupants increases and that 
any such increase in the occupants' gross rent reduce equally the 
Federal rental assistance payment, then the gross rent paid by the 
tenant may exceed 30 percent of the applicable income limit to the 
extent required under the applicable Federal housing program stat- 
ute. 



17 

Special rules for multiple building projects 

The bill provides new rules for determining whether a building is 
part of a qualified low-income housing project in the case of multi- 
ple building projects. In such a project, buildings need not meet the 
minimum low-income set-aside requirement only by reference to 
the order that the buildings are placed in service. If within 12 
months of the placed-in-service date of a prior building the project 
meets the set-aside requirement with respect to the first building 
and any subsequent buildings placed in service within the 12- 
month period, then the first building and included subsequent 
buildings are part of a qualified low-income project. Subsequent 
buildings not included in determining whether the project satisfies 
the set-aside requirement with respect to prior buildings have their 
own 12-month period before they are required to be included in the 
set-aside determination for the project. 

De minimis exception to disproportionate cost limit 

The bill permits a portion of the basis of housing units whose 
cost is disproportionate to that of the low-income units to be includ- 
ed in eligible basis. Unless otherwise provided by Treasury regula- 
tions, to be eligible for this exception, the cost per square foot of 
the disproportionate unit may not exceed by 15 percent the average 
cost per square foot of the low-income units. If cost differentials 
exceed 15 percent, the cost of the entire disproportionate unit must 
be excluded from eligible basis, as under present law. 

The bill further provides that costs with respect to which an elec- 
tion was made by the taxpayer to deduct rehabilitation expendi- 
tures under prior law section 167(k) may not be included in eligible 
basis. 

Exceptions to 10-year rule 

The bill provides several exceptions to the restriction that build- 
ings eligible for an aquisition credit may not have been previously 
placed in service within 10 years of the date of acquisition. Under 
these exceptions, a placement in service is disregarded if it is as a 
result of (1) death, (2) acquisition by a governmental unit or certain 
qualified 501(c)(3) or 501(c)(4) organizations whose acquisition of the 
property was at least 10 years after it was previously placed in 
service, or (3) a foreclosure occurring at least 10 years after the 
previous placed-in-service date, provided the property is resold 
within 12 months of such foreclosure. 

Amendments affecting State credit authority 

The bill provides that the State low-income housing credit au- 
thority must allocate credits to a building in the calendar year it is 
placed in service, unless (1) credits are allocated as the result of ad- 
ditions to qualified basis or (2) the authority makes a binding com- 
mitment no later than the last day of such year to allocate a speci- 
fied amount of credits to the building in a later year. An allocation 
in a later calendar year pursuant to a binding commitment is 
counted against the State's credit authority limitation in such later 
year. Such later allocation does not defer the start of the credit 
period or the compliance period. 



18 

The bill further provides that, if for reasons unforeseen and 
beyond the control of the taxpayer which occur after an allocation 
of credit authority to a building, a building cannot be placed in 
service in the year for which an allocation was made, then upon 
approval by the Treasury Department, the credit allocation will be 
valid for that building if the building is placed in service in the 
first succeeding year after the year of the original allocation. This 
provision is effective beginning in 1988. 

The bill provides that if a corporation is wholly owned by one or 
more qualified nonprofit organizations and such corporation mate- 
rially participates in the development and operation of a qualified 
low-income project, the qualified nonprofit organization(s) will be 
treated as materially participating in the development and oper- 
ation of such project for purposes of this section. 

Recapture 

The bill makes several modifications to the rules regarding re- 
capture of the credit. First, the bill provides that there will be no 
recapture for certain de minimis changes in the qualified basis by 
reason of changes in floor space of low-income housing units. 
Second, for partnerships more than 50 percent of which are owned 
by 35 or more natural persons or estates, the presence of a corpo- 
rate partner will not exclude the partnership from a special rule 
under which recapture is determined at the partnership, rather 
than the partner, level. 

Other amendments 

The bill clarifies that, similar to other Federally subsidized loans, 
the proceeds of an issue of tax-exempt obligations used to finance a 
building may be excluded from eligible basis and the building will 
not be treated as federally subsidized. 

The bill provides that tax-exempt financing or a below market 
loan used to provide construction financing for a building will not 
be treated as a Federal subsidy if such loan is repaid and any un- 
derlying obligation (e.g., tax-exempt bond) is redeemed before the 
building is placed in service. 

The bill modifies the at-risk provisions applicable to certain fi- 
nancing from qualified nonprofit organizations in the case of cer- 
tain federally assisted buildings in which a security interest is not 
permitted by a Federal agency. 

The bill provides certain information reporting requirements on 
owners of qualified low-income housing projects and imposes a pen- 
alty for failure to provide required information. 

The bill clarifies that the sunset of credit authority to buildings 
placed in service after 1990 also applies to buildings financed with 
the proceeds of tax-exempt bonds not requiring an allocation of 
credit authority. 

The bill provides that credits may not be carried back to taxable 
years ending before January 1, 1987. 

The bill makes clarifying amendments to certain transitional 
rules of limited application. 

The bill also corrects other minor clerical and technical errors. 



III. Capital Gains and Losses (Sec. 103 of the Bill) 

1. Individual and corporate capital gains (sec. 103(a)-(c) of the 

bill, sees. 301-311 of the Reform Act, and various sees, of the 
Code) 

Present Law 

The Act repealed the prior law capital gains deduction for indi- 
viduals and repealed the alternative tax rate on capital gains for 
corporations. 

Explanation of Provision 

The bill makes several conforming amendments to the repeal of 
the special capital gains treatment, including amendments relating 
to the computation of foreign source capital gain net income (sec. 
904), the exclusion of capital gains by certain financial institutions 
in computing bad debt reserves under the taxable income method 
(sec. 593(b)), and the effective date for certain withholding changes. 

The bill also repeals a transitional rule for specified taxpayers. 

2. Incentive stock options (sec. 103(d) of the bill, sec. 321 of the 

Reform Act, and sec. 422 A of the Code) 

Present Law 

Under present law, generally an employee is not taxed on the 
grant or exercise of an incentive stock option (as defined in section 
422A(b)) and the employer is not allowed a deduction when the 
option is granted or exercised. The Act made several changes in 
the definition of an incentive stock option, including a change to 
provide that under the terms of the plan, the aggregate fair 
market value (at the time of grant of an option) of the stock with 
respect to which incentive stock options are first exercisable during 
any calendar year may not exceed $100,000. 

Explanation of Provision 

The bill provides that an option shall not be treated as an incen- 
tive stock option if, at the time the option is granted, the terms of 
the option provide that it will not be treated as an incentive stock 
option. Thus, an option that otherwise satsisfies the requirements 
of section 422A(b) shall not be treated as an incentive stock option 
if, at the time of grant, the option is designated as not constituting 
an incentive stock option. In the case of an option granted after De- 
cember 31, 1986, and before the date of enactment of this bill, an 
option will not be treated as an incentive stock option if the terms 
of the option are so amended before 90 days after the enactment of 
this bill. 

(19) 



20 

The bill also deletes the $100,000 requirement added by the Act 
and instead provides that to the extent the aggregate fair market 
value (determined at the time the option is granted) of stock with 
respect to which options meeting the requirements of section 
422A(b) are exercisable for the first time by any individual during 
any calendar year (under all plans of the individual's employer cor- 
poration and its parent and subsidiary corporations) exceeds 
$100,000, then such options shall not be treated as incentive stock 
options. This rule is applied by taking options that meet the re- 
quirements of section 422A(b) and are exercisable for the first time 
in the calendar year into account in the order granted. 



IV. Agriculture Provisions (Sec. 104 of the Bill) 

1. Treatment of discharge of indebtedness income of certain farm- 
ers (sec. 104(a) of the bill, sec. 405 of the Reform Act, and 
sees. 108 and 1017 of the Code) 

Present Law 

Under present law, if an insolvent taxpayer realizes income from 
discharge of indebtedness, the income is excluded and the taxpay- 
er's tax attributes and basis in property are reduced by the ex- 
cluded amount (sec. 108). The exclusion is limited to the amount by 
which the taxpayer is insolvent. Reduction of attributes and basis 
occurs in the following order: net operating losses and carryovers, 
general business credit carryovers, capital loss carryovers, basis of 
property, and foreign tax credit carryovers.^ The reduction in the 
basis of property is limited to the excess of the aggregate bases of 
the taxpayer's property over the taxpayer's aggregate liabilities im- 
mediately after the discharge (sec. 1017). If the taxpayer's dis- 
charge of indebtedness income (not in excess of the amount by 
which the taxpayer is insolvent) exceeds the available tax at- 
tributes and basis, the excess is forgiven, i.e., is not includible in 
income. 

The Act provides that, in the case of a solvent taxpayer who real- 
izes income from the discharge by a "qualified person" of "quali- 
fied farm indebtedness," the discharge is treated in the same 
manner as if incurred while the taxpayer was insolvent. Qualified 
farm indebtedness is indebtedness incurred directly in connection 
with the operation of a farming business by a taxpayer who satis- 
fies a specified gross receipts test. The gross receipts test is satis- 
fied if 50 percent or more of the taxpayer's average annual gross 
receipts for the three taxable years preceding the taxable year in 
which the discharged indebtedness occurs is attributable to the 
trade or business of farming. A qualified person is one regularly 
engaged in the business of lending money and meeting certain 
other requirements. 

Any amount excluded from income under the special rules for 
qualified farm indebtedness must be used first to reduce tax at- 
tributes; then to reduce basis of property other than land used or 
held for use in a farming business; and finally to reduce the basis 
of land used or held for use in a farming business (sec. 1017). 

Explanation of Provision 

The bill clarifies that, for purposes of determining whether a tax- 
payer's indebtedness is qualified farm indebtedness, the gross re- 



' An election is provided under which the taxpayer may reduce basis in depreciable property 
before reducing net operating losses or other attributes. 

(21) 



22 

ceipts test is applied by dividing the taxpayer's aggregate gross re- 
ceipts from farming for the three-taxable-year period preceding the 
taxable year of the discharge by the taxpayer's aggregate gross re- 
ceipts from ail sources for that period. In addition, the term "quali- 
fied person" is modified to include a Federal, State, or local govern- 
ment or agency or instrumentality thereof. 

The bill provides that, after reducing tax attributes in the order 
prescribed for insolvent taxpayers, amounts excluded from income 
under the qualified farm indebtedness provision may be applied to 
reduce basis in assets used or held for use in a trade or business or 
for the production of income (i.e., in "qualified property"). Basis re- 
duction occurs first with respect to depreciable property, then with 
respect to land used in the business of farming, and then with re- 
spect to other qualified property. 

The amount excluded under this provision may not exceed the 
taxpayer's total available attributes and basis in qualified property. 
Accordingly, to the extent there is unabsorbed discharge of indebt- 
edness income after the taxpayer has reduced tax attributes and 
basis in qualified property, income will be recognized. 

2. Retention of capital gains treatment for sales of dairy cattle 
under milk production termination program (sec. 104(b) of 
the bill and sec. 406 of the Reform Act) 

Present Law 

The Act generally repealed the prior-law deduction for 60 per- 
cent of long-term capital gains of noncorporate taxpayers and the 
alternative tax for long-term capital gains of corporations. Howev- 
er, these amendments made by the Act do not apply to any gain 
from the sale of dairy cattle under a valid contract with the tFnited 
States Department of Agriculture under the milk production termi- 
nation program to the extent such gain is properly taken into ac- 
count under the taxpayer's method of accounting after January 1, 
1987 and before September 1, 1987. 

Explanation of Provision 

The bill clarifies that the amendments made by the Act with re- 
spect to capital gains do not apply to gain properly taken into ac- 
count under the taxpayer's method of accounting on or after Janu- 
ary 1, 1987, and before October 1, 1987, (rather than after January 
1, 1987 and before September 1, 1987). 

The transition provision applies only to gains that would be cap- 
ital gains under the generally applicable provisions of the law. See, 
e.g., IRS Notice 87-26, 1987-10 IRB 16. (February 26, 1987). The 
transition provision does not recharacterize any payments that 
would not otherwise be capital gains. 



V. Tax Shelters; Interest Expense (Sec. 105 of the Bill) 

1. Passive loss rules (sec. 105(a) of the bill, sec. 501 of the Reform 
Act, and sec. 469 of the Code) 

Present Law 

Present law, as amended by the Reform Act, provides that deduc- 
tions from passive trade or business activities, to the extent they 
exceed income from all such passive activities (exclusive of portfo- 
lio income), generally may not be deducted against other income. 
Similarly, credits from passive activities generally are limited to 
the tax attributable to the passive activities. Suspended losses and 
credits are carried forward and treated as deductions and credits 
from passive activities in the next year. Suspended losses (but not 
credits) are allowed in full when the taxpayer disposes of his entire 
interest in the activity to an unrelated party in a transaction in 
which all realized gain or loss is recognized. 

The provision applies to individuals, estates, trusts, and personal 
service corporations. A special rule prohibits the use of passive ac- 
tivity losses and credits against portfolio income in the case of 
closely held corporations. Losses and credits attributable to a limit- 
ed partnership interest generally are treated as arising from a pas- 
sive activity (except as provided in regulations). Rental activities 
are defined as passive activities. Special rules provide that up to 
$25,000 of losses and (deduction equivalent) credits from rental real 
estate activities (those in which the taxpayer actively participates, 
with an exception for certain credits) are allowed against other 
income for the year. Losses from certain working interests in oil 
and gas property are not limited by the provision. The provision is 
effective for taxable years beginning after 1986. For certain pre-en- 
actment interests in passive activities, the provision is phased in, 
and becomes fully effective for taxable years beginning in 1991 and 
thereafter. 

Explanation of Provisions 

Definition of portfolio income. — The bill clarifies that income not 
treated as from a passive activity includes gain or loss that is not 
derived in the ordinary course of a trade or business, in the case of 
a disposition of property held for investment or property that gen- 
erally produces income in the nature of interest, dividends, annu- 
ities or royalties. Gain or loss upon disposition of such property, 
where the gain or loss is derived in the ordinary course of a trade 
or business, is not automatically treated as not from a passive ac- 
tivity under this rule; rather, the general rules applicable to deter- 
mining whether an activity is passive (e.g., whether the taxpayer 
materially participates) apply. 

(23) 



24 

Dispositions. — The bill restates the rules applicable to the allow- 
ance of suspended losses upon a disposition of an interest in a pas- 
sive activity. 

In addition, the bill provides that, pursuant to regulations, to the 
extent necessary to prevent avoidance of the provision, income or 
gain from a passive activity in taxable years preceding the taxpay- 
er's disposition of the activity is taken into account in determining 
the amount of the loss allowed against non-passive income upon 
disposition. Regulatory authority might appropriately be exercised, 
for example, in situations where passive activities produce taxable 
passive income in the initial years of an investment and then a loss 
upon disposition, such as where the investment is structured so 
that income is recognized in years prior to the allowance of related 
deductions. 

The bill also makes several clerical amendments to the provi- 
sions relating to dispositions. 

Special rule for rental real estate activities. — The bill clarifies the 
application of the active participation requirement for the allow- 
ance of up to $25,000 of losses (or deduction equivalent credits, 
where applicable) from certain rental real estate activities. The bill 
provides that the active participation requirement applies both in 
the year when the loss arose, and in the year when the loss is al- 
lowed under the $25,000 allowance. (The active participation re- 
quirement does not apply to low income housing or rehabilitation 
credits otherwise allowable under the $25,000 allowance.) 

The bill also modifies the rule that an interest in an activity as a 
limited partner is not treated as an interest with respect to which 
the taxpayer actively participates. Under the bill, this rule applies 
except as otherwise provided in regulations. 

Coordination with rental use of dwelling. — The bill provides that 
income, deductions, gain or loss from rental use of a dwelling that 
the taxpayer uses as a residence (or from certain other business 
uses of a dwelling), for any taxable year in which deductions from 
such use are limited to the amount of income from such use under 
Code sec. 280A(c)(5), are not taken into account in determining the 
taxpayer's passive activity loss for the year. This provision elimi- 
nates the partial overlap of the deduction limitations imposed by 
sec. 280A(c)(5) and by the passive loss rules, principally in the cir- 
cumstance of rental use of residences, and thus tends to simplify 
the application of these rules. 

Affiliated groups. — The bill clarifies that for purposes of the pas- 
sive loss rule, all members of an affiliated group that files a con- 
solidated tax return are treated as one corporation, except as other- 
wise provided in regulations. 

Certain installment sales. — The bill treats as income from a pas- 
sive activity, gain that is recognized in a taxable year beginning 
after 1986 from the disposition (in a taxable year beginning before 
1987) of an interest in an activity that would have been treated as 
a passive activity within the meaning of sec. 469. Thus, under the 
bill, income from passive activities includes post-1986 gain from the 
pre-1987 installment sale of an activity that the taxpayer can show 
would be treated as a passive activity if he had held it in his first 
taxable year after 1986 (when the passive loss rule applies). 



25 

The bill also makes clerical amendments to the definition provi- 
sions of the passive loss rule. 

2. Investment interest limitation (sec. 105(c) of the bill, sec. 511 of 
the Reform Act, and sec. 163(d) of the Code) 

Present Law 

Under present law, in the case of noncorporate taxpayers, the de- 
duction for investment interest expense is limited to the amount of 
net investment income for the year. Investment interest disallowed 
for the year is carried forward and treated as investment interest 
paid or accrued in the succeeding taxable year, and is allowable to 
the extent the taxpayer has net investment income in such year. 

Investment interest is defined to include interest paid or accrued 
on indebtedness incurred or continued to purchase or carry proper- 
ty held for investment. For this purpose, property held for invest- 
ment includes an interest in a trade or business activity that is 
treated as not a passive activity, but in which the taxpayer does 
not materially participate, within the meaning of the passive loss 
rule. Investment interest also includes interest expense properly al- 
locable to portfolio income under the passive loss rule. Investment 
income is defined under present law as gross income from, and 
gain from the disposition of, property held for investment, to the 
extent such amounts are not derived from the ordinary conduct of 
a trade or business. 

The provisions of the Reform Act affecting the investment inter- 
est limitation are phased in, so that the amended provisions 
become fully effective for taxable years beginning in 1991 and 
thereafter. 

Explanation of Provisions 

Investment interest. — The bill conforms the language of the defi- 
nition of investment interest to the language of a related provision 
that allocates interest expense to portfolio income under the pas- 
sive loss rule. Thus, under the bill, investment interest is that 
which is properly allocable to property held for investment. This 
change results in consistency in the language of the provisions allo- 
cating interest expense to the category of investment interest, and 
permits consistent application of a standard for allocation of inter- 
est. This change is not intended to suggest the adoption of any par- 
ticular method of allocation, but rather to give Treasury the ability 
to devise allocation rules as simple as possible consistent with the 
objectives of the provision. 

Investment income. — The bill conforms the definition of invest- 
ment income to the definition of investment interest, by deleting 
the provision that amounts are treated as investment income only 
to the extent such amounts are not derived from the conduct of a 
trade or business. 

Phase-in rule. — The bill clarifies the operation of the phase-in 
rule. The bill provides that the amount of current year's invest- 
ment interest disallowed during any taxable year in the phase-in 
period shall not exceed the sum of (1) the amount that would be 
disallowed if: (a) the net investment income were increased by the 



26 

ceiling amount (generally $10,000), (b) the reduction of net invest- 
ment income by passive losses allowed under the passive loss 
phase-in rule did not apply, and (c) an interest in any activity that 
is not treated as passive and in which the taxpayer does not mate- 
rially participate were not treated as held for investment; and (2) 
the applicable percentage for such year (e.g., 35 percent in 1987) of 
the amount which would be disallowed, under the fully phased-in 
investment interest limitation, over the amount determined under 
(1) above. 

3. Personal interest limitation (sec. 105(c) of the bill, sec. 511 of 
the Reform Act, and sec. 163(h) of the Code) 

Present Law 

Under present law, as amended by the Reform Act, personal in- 
terest is not deductible. Personal interest is any interest, other 
than interest incurred or continued in connection with the conduct 
of a trade or business (other than the trade or business of perform- 
ing services as an employee), investment interest, or interest taken 
into account in computing the taxpayer's income or loss from pas- 
sive activities for the year. 

Present law provides that qualified residence interest is not sub- 
ject to the limitation on personal interest. Qualified residence in- 
terest is interest on debt secured by a security interest valid 
against a subsequent purchaser on the taxpayer's principal resi- 
dence or a second residence of the taxpayer. Interest on such debt 
is deductible to the extent that the debt does not exceed the 
amount of the taxpayer's basis for the residence (including the cost 
of home improvements), plus the amount of qualified medical and 
qualified educational expenses, and to the extent the amount of the 
debt does not exceed the fair market value of the residence. A 
grandfather rule is provided in the case of debt incurred on or 
before August 16, 1986 and secured by the taxpayer's principal or 
second residence. Interest on such debt (reduced by any principal 
payments thereon) is generally treated as qualified residence inter- 
est, provided the amount of the debt does not exceed the fair 
market value of the residence. The personal interest limitation is 
phased in for taxable years beginning after 1986, and becomes fully 
effective for taxable years beginning in 1991 and thereafter. 

Explanation of Provisions 

Personal interest. — The bill conforms the language of the defini- 
tion of personal interest to the language of related provisions (the 
passive loss rule and the investment interest limitation) under 
which interest expense may be allocated. Thus, the bill provides 
that personal interest does not include interest that is properly al- 
locable to a trade or business. This change results in consistency in 
the language of several significant provisions under which interest 
is likely to be allocated, and permits consistent application of a 
standard for allocation of interest. 

Refinancing of grandfathered debt. — The bill provides that inter- 
est on indebtedness secured by a qualified residence and incurred 
after August 16, 1986, to refinance grandfathered indebtedness (for 



27 

example, to obtain a lower interest rate) will be treated as qualified 
residence interest if certain requirements are met. 

Indebtedness secured by the qualified residence and incurred 
after August 16, 1986 to refinance pre-August 17, 1986 grandfa- 
thered indebtedness qualifies under this rule to the extent that the 
principal amount of the refinancing does not exceed the principal 
amount of the pre-August 17, 1986 grandfathered indebteness im- 
mediately before the refinancing. The refinancing exception will 
cease to apply, however, after the expiration of the period of the 
pre-August 17, 1986 indebtedness. Thus, if the pre-August 17, 1986 
indebtness was scheduled to be repaid at the end of 1992, interest 
on any refinancing of that debt, to the extent not otherwise deduct- 
ible, will not be deductible for any period after 1992. Where the 
pre-August 17, 1986 debt was not amortized over its term (e.g., a 
"balloon" note), interest on any otherwise qualified refinancing of 
that debt will be deductible for the term of the first refinancing of 
the pre-August 17,1986 indebtedness (but not for more than 30 
years after that refinancing). A refinancing of indebtness originally 
incurred after August 16, 1986 to refinance pre-August 17, 1986 
grandfathered indebtedness (e.g., a second refinancing of such pre- 
August 17, 1986 debt) can also qualify under this rule subject to 
these requirements. 

Thus, under the provision, the current balance (taking into ac- 
count all amortization of principal) of the debt secured by the tax- 
payer's residence and incurred on or before August 16, 1986, that 
was grandfathered under the Reform Act, can be refinanced. 

Use of residence. — The bill clarifies the definition of a residence 
of the taxpayer that is treated as a qualified residence, interest on 
debt secured by which may be treated as deductible qualified resi- 
dence interest. Under the bill, a residence may be treated as a 
qualified residence even if the taxpayer does not use it as such at 
least 14 days a year or 10 percent of the time it is rented (whichev- 
er is greater), provided that the residence is not rented at all 
during the year. 

Unenforceable security interest. — The bill provides that interest 
on a loan secured by a recorded deed of trust, mortgage, or other 
security interest in a taxpayer's principal or second residence, in a 
State such as Texas where such security instrument will be ren- 
dered ineffective or the enforceability of such instrument will be 
otherwise restricted by State and local homestead or other debtor 
protection law such as the Texas homestead law, shall be treated 
as qualified residence interest, provided that such interest is other- 
wise qualified residence interest. 

Transfer incident to divorce. — The bill provides that in certain 
circumstances involving a transfer of a qualified residence between 
spouses incident to a divorce or legal separation, the basis limita- 
tion on debt, interest on which may be deductible, may be in- 
creased by the amount of secured indebtedness incurred by a 
spouse in connection with the acquisition of the other spouse's in- 
terest in the residence. The amount of such debt may not, however, 
exceed the fair market value of the interest in the residence that is 
being acquired. 

In addition, the bill makes several clerical amendments to the 
personal interest limitation provisions. 



VI. Corporate Tax Provisions (Sec. 106 of the Bill) 

A. Corporate Tax Rate (sec. 106(a) of the bill, sec. 601 of the 
Reform Act, and sec. 15 of the Code) 

Present Law 

The Act revised corporate tax rates, effective for taxable years 
beginning on or after July 1, 1987. Under the Act, the maximum 
corporate tax rate under section 11 of the Code for such taxable 
years is 34 percent (rather than 46 percent, as under prior law). 
Income in taxable years that include July 1, 1987 (other than as 
the first date of such year) is subject to a blended rate under the 
rules specified in section 15 of the Code. 

Certain other provisions of the Code require a determination of 
the maximum corporate tax rate under section 11 for a particular 
taxable year, for purposes other than imposing a tax by reference 
to such rate. Such provisions include the "high-taxed income" pro- 
visions of sections 904(d)(2)(F) and 954(b)(4) of the Code, which pro- 
vide special treatment for certain income that is subject to foreign 
taxes exceeding the highest rate of tax under sections 1 or 11 of the 
Code (or 90 percent of such rate, in the case of section 954). 

Explanation of Provision 

The bill clarifies that any reference in the income tax provisons 
of the Code to the highest rate of tax imposed by section 1 ^ or sec- 
tion 11(b) of the Code (other than a provision imposing a tax by ref- 
erence to such rate) shall be treated as a reference to the weighted 
average of the highest rates before and after the change deter- 
mined on the basis of the respective portions of the taxable year 
before the date of change and on or after the date of the change. 
For example, in the case of a calendar year corporate taxpayer, the 
highest rate under section 11(b) for the calendar year 1987 would 
be 39.95% (181/365 x 46% and 184/365 x 34%).2 

B. Dividends Received Deduction: Certain Dividends Received 
From a Foreign Sales Corporation (sec. 106(b) of the bill, sees. 
611 and 612 of the Reform Act, and sec. 245(c) of the Code) 

Present Law 

The Act reduced to 80 percent the prior law 85 percent deduction 
that generally applied to dividends received by corporations. The 



' The reference to section 1 of the Code has no application to the non-corporate rate changes 
imposed by the Act because the Act does not subject the changes under section 1 to section 15 of 
Code. However, if any future legislation were to impose a rate change under section 1 that is 
subject to section 15, the provision would apply to such change. 

^ 181 is the number of days in calendar year 1987 prior to July 1; 184 is the number of days in 
the calendar year 1987 on or after July 1. 

(28) 



29 

Act did not affect the 100 percent dividends received deduction that 
applies in certain situations. 

Under prior law, an 85 percent dividends received deduction was 
allowed to a domestic corporation for certain dividends attributable 
to qualified interest and carrying charges received or accrued by 
the payor corporation while it was a foreign sales corporation 
(FSC). 

Explanation of Provision 

The bill conforms the amount of the dividends received deduction 
for certain dividends attributable to qualified interest and carrying 
charges received or accrued by the payor corporation while it was a 
FSC to the general reduction, under the Act, of the 85 percent divi- 
dends received deduction to 80 percent. Accordingly, under the bill, 
the amount of the dividends received deduction for such dividends 
is reduced to 80 percent. 

The bill makes certain other conforming and clerical amend- 
ments. 

C. Extraordinary Dividends Received by Corporate Shareholders 
(sec. 106(c) of the bill, sec. 614 of the Reform Act, and sec. 1059 
of the Code) 

Present Law 

Under the Act, if a corporation receives an extraordinary divi- 
dend and has not held the stock subject to a risk of loss for a speci- 
fied holding period (described below), the corporation must reduce 
its basis in the stock with respect to which the dividend was paid 
by the nontaxed portion of the dividend (i.e., the portion of the divi- 
dend eligible for the dividends received deduction). An extraordi- 
nary dividend is generally defined as one exceeding certain 
''threshold" amounts. 

The Act provided a holding period requirement, under which 
basis reduction is required if the stock is not held subject to a risk 
of loss for more than two years before the dividend announcement 
date. The dividend announcement date is defined in the Act as the 
date on which the corporation declares, announces, or agrees to the 
payment of the dividend, whichever is the earliest.^ 

The Act also provided that certain distributions are treated as 
extraordinary dividends without regard to the recipient's holding 
period or the amount of the dividend. The distributions subject to 



^ Although the amount of any fixed dividend on preferred stock is in a sense "announced" by 
the terms of the stock at the time the stock is acquired, all such fixed dividends on the stock, 
however long it is held, are not thus considered to be "announced or agreed to" within the 2- 
year period. However, the fixed dividends attributable to the first 2 years the preferred stock is 
held are considered "announced or agreed to" within the first two years, even though a pay- 
ment date might be missed or there might otherwise be a delay in paying such dividends beyond 
the first 2 years to which they are attributable. 

Similarly, if preferred stock provides for a cumulative dividend of a specified percentage of 
annual profits, the dividends attributable to the first 2 years profits are subject to the extraordi- 
nary dividends rule and basis reduction is required with respect to such dividends if the thresh- 
old percentage is exceeded, even if the dividends are not paid until the third year. 

The basis reduction rules also apply in other situations that avoid the threshold amount or 
holding period requirements by deferring or staggering dividend payments. 



30 

this rule are any non pro-rata redemption and any redemption in 
partial liquidation constituting a dividend. 

The Act provided a special relief provision applicable to certain 
qualifying preferred dividends. Under this provision, certain divi- 
dends that would otherwise require basis reduction because the 
more than two-year holding period is not met, may be eligible for a 
reduced amount of basis reduction or no basis reduction if the 
stock is either held for five years or if the dividends received do not 
exceed the dividends "earned", based on the stock's stated rate of 
return. This relief provision applies only in the case of certain pre- 
ferred dividends on stock which provides for fixed dividends pay- 
able at least annually, with respect to which the taxpayer's actual 
rate of return does not exceed 15 percent. Furthermore, relief is 
available only to the extent the taxpayer's actual rate of return 
does not exceed the stated rate of return. 

The Act provided an exception under which no basis reduction is 
required in the case of an otherwise extraordinary dividend re- 
ceived with respect to stock of a corporation if: (a) the taxpayer has 
held the stock during the entire period such corporation was in ex- 
istence, (b) the only earnings and profits of the corporation were 
earnings and profits accumulated during such period, and (c) the 
application of the exception is not inconsistent with the purposes of 
the extraordinary dividend provision. 

The Act also provided an exception under which no basis reduc- 
tion is required in the case of any qualifying dividend within the 
meaning of section 243(b)(1) of the Code. This provision was also in- 
tended to apply only where earnings and profits would directly or 
indirectly be solely attributable to the distributee shareholders in 
the case of distributions that constitute qualifying dividends within 
the meaning of section 243(b)(1), including such distributions be- 
tween members of an affiliated group filing a consolidated return. 
To the extent the consolidated return regulations would require 
basis reduction in any event, the Act does not simultaneously apply 
to dividend distributions (or deemed dividend distributions) be- 
tween members of an affiliated group filing consolidated returns. 

Explanation of Provision 

The bill clarifies that the dividend announcement date, with re- 
spect to which the holding period requirement is tested, is the date 
on which the corporation declares, announces, or agrees to either 
the amount or the payment of the dividend, whichever is earliest. 
Thus, if the amoupt of a dividend is announced or agreed to within 
the two-year period, the fact that its payment may not have been 
announced or agreed to is irrelevant. 

The bill clarifies that the nontaxed portion of any dividend that 
is a non pro-rata distribution or a partial liquidation distribution 
reduces basis, without regard to whether the two-year holding 
period requirement has been met. 

The bill also clarifies the application of the special exception for 
dividends on stock that has been held during the entire existence 
of a corporation. This relief provision was intended to permit distri- 
butions without basis reduction, even through the distributions 
exceed the threshold percentage and are declared, announced or 



31 

agreed to within the two-year holding period, only in those cases in 
which the earnings and profits from which the dividend is paid 
could not have been attributable, directly or indirectly, to any 
person other than the original shareholder receiving the distribu- 
tion. For this purpose, earnings and profits are not considered at- 
tributable solely to such shareholder if any more than a de mini- 
mis part of such earnings and profits is derived, directly or indi- 
rectly, from any other entity in which the shareholder was not an 
original shareholder with an interest at least as great as such 
shareholder's original and continuing interest in the distributing 
corporation at the time of the distribution. 

Thus, for example, the relief provision does not apply if any 
more than a de minimis part of the earnings and profits from 
which the dividend is paid were derived (e.g., by distribution or by 
a transaction described in sec. 381) directly or indirectly from an- 
other corporation in which the original shareholder did not at all 
times hold at least as great an interest as such shareholder's inter- 
est in the distributing corporation at the time of the distribution. 

However, the fact that the distributing corporation directly or in- 
directly received de minimis amounts of earnings and profits from 
other entities (such as non-extraordinary dividends received from 
temporary portfolio investments of funds), would not generally be 
expected to preclude the application of the relief provision. 

The bill clarifies that earnings and profits would be indirectly at- 
tributable to a person other than the shareholder receiving the dis- 
tribution if they are attributable to transfers or distributions from 
any corporation that is not a "qualified corporation". A qualified 
corporation is one in which the shareholder receiving the dividend 
holds, directly or indirectly, at least as great an interest, through- 
out the entire existence of such corporation, as such shareholder 
has held throughout the period the corporation paying the dividend 
in question was in existence. In addition, a qualified corporation 
must have no earnings and profits which were earned by any 
person, or are attributable to gain on property which accrued 
during a period in which any person held such property, if the 
shareholder did not, throughout such corporation's or other per- 
son's existence, hold the requisite interest in such corporation or 
other person. 

The bill similarly clarifies the exception for dividends that qual- 
ify under section 243(b)(1) of the Code, providing thaL such divi- 
dends do not qualify for the exception to the extent they are attrib- 
utable to earnings and profits earned by a corporation during a 
period it was not a member of the affiliated group, or allocable to 
gain on property which accrued during a period the corporation 
holding the property was not a member of the affiliated group. It is 
expected that the application of the provision in the consolidated 
return context will be consistent with this approach. 

The bill clarifies that only fixed dividends (i.e., dividends that do 
not vary in amount from period to period) are eligible for the spe- 
cial relief provision for qualified preferred dividends. 

The bill deletes section 1059(d)(5) of the Code as deadwood. 



32 

D. Special Limitations on Net Operating Loss and Other 
Carryforwards 

1. Value of loss corporation: Special rule in the case of redemp- 

tion (sec. 106(d)(1) of the bill, sec. 621(a) of the Reform Act, 
and sec. 382(e) of the Code) 

Present Law 

After a more than 50 percent change in ownership, the taxable 
income of a loss corporation available for offset by pre-acquisition 
NOL carryforwards is limited by a prescribed rate times the value 
of the loss corporation's stock immediately before the ownership 
change. Debt thus reduces value for purposes of the limitation. 
Under a special rule, if a redemption occurs in connection with an 
ownership change — either before or after — the value of the loss cor- 
poration's stock is determined after taking the redemption into ac- 
count. Also, redemptions are taken into account in determining 
whether a loss corporation has a built-in gain or loss. Further, the 
Secretary is authorized to prescribe regulations providing for the 
treatment of corporate contractions as redemptions. 

Explanation of Provision 

In lieu of regulatory authority, the bill extends the statutory 
rules for redemptions to other corporate contractions. The rule for 
redemptions was intended to apply to transactions that effect simi- 
lar economic results, without regard to formal differences in the 
structure used or the order of events by which similar conse- 
quences are achieved. Thus, for example, the fact that a transac- 
tion might not constitute a "redemption" for other tax purposes 
does not determine the treatment of the transaction under this pro- 
vision. As one example, a "bootstrap" acquisition, in which aggre- 
gate corporate value is directly or indirectly reduced or burdened 
by debt to provide funds to the old shareholders, is subject to the 
provision. This includes cases in which debt used to pay the old 
shareholders remains an obligation of an acquisition corporation or 
an affiliate, where the acquired loss corporation is directly or indi- 
rectly the source of funds for repayment of the obligation. 

The bill also clarifies that if the old loss corporation is a foreign 
corporation, its value shall be determined taking into account only 
assets and liabilities treated as connected with the conduct of a 
trade or business in the United States.'* 

2. Definition of ownership change: Owner shift involving five-per- 
cent shareholder and equity structure change (sec. 106(d)(2) of 
the bill, sec. 621(a) of the Reform Act, and sec. 382(g)(4)(C) of 
the Code) 

Present Laiv 

An ownership change occurs if the percentage of stock in a loss 
corporation owned by one or more five-percent shareholders in- 



* This provision relating to foreign corporations applies only to ownership changes occurring 
after June 10, 1987 (the date of introduction of the bill). 



33 

creases by more than 50 percentage points relative to the lowest 
percentage of such stock owned by those shareholders during a 
testing period. The determination whether an ownership change 
has occurred is made after any owner shift involving a five-percent 
shareholder or any equity structure shift. 

An owner shift involving a five-percent shareholder is defined as 
any change in the respective ownership of stock in a corporation 
that affects the percentage of stock held by any person who holds 
five percent or more of stock in the corporation before or after the 
change. An equity structure shift is defined as any tax-free reorga- 
nization within the meaning of section 368, other than a divisive 
"D" or "G" reorganization oi; an "F" reorganization. For purposes 
of these definitions, all less-than-five-percent shareholders are ag- 
gregated and treated as a single five-percent shareholder. 

In determining whether an equity structure shift has occurred, 
the rule that aggregates less-than-five-percent shareholders is ap- 
plied separately with respect to each group of shareholders of each 
corporation that is a party to the reorganization ("segregation 
rule"). Except as provided in regulations, the segregation rule ap- 
plies in determining whether there has been an owner shift involv- 
ing a five-percent shareholder; the regulatory authority in section 
382(m) augments this rule for cases that involve only a single cor- 
poration. To the extent provided in regulations, transactions in 
which it is feasible to identify changes in ownership involving less- 
than-five-percent shareholders will be treated under the rules for 
equity structure shifts. 

Explanation of Provision 

The bill amends section 382(g)(4)(C) to clarify that rules similar 
to the segregation rule apply to acquisitions by groups of less-than- 
five-percent shareholders through corporations as well as other en- 
tities (e.g., partnerships), and in transactions that do not constitute 
equity structure shifts. 

The regulatory authority in section 382(g)(3)(B) — to treat transac- 
tions under the rules for equity structure shifts — does not limit the 
scope of section 382(g)(4)(C). Section 382(g)(4)(C), by its terms, gener- 
ally causes the segregation of the less-than-five-percent sharehold- 
ers of separate entities where an entity other than a single corpo- 
ration is involved in a transaction. Section 382(g)(3)(B) merely pro- 
vides additional authority, as does section 382(m), for cases in 
which only one corporation is involved. 

3. Special rules for built-in gains and losses and section 338 gains 
(sec. 106(d)(2) of the bill, sec. 621(a) of the Reform Act, and 
sec. 382(h) of the Code) 

Present Law 

If a loss corporation has a net unrealized built-in gain, the sec- 
tion 382 limitation for any taxable year ending within a five-year 
recognition period is increased by the recognized built-in gain for 
the taxable year. A net unrealized built-in gain is the amount by 
which the fair market value of a corporation's assets exceeds the 
aggregate adjusted basis of those assets immediately before an own- 



34 

ership change. The definition of a net unrealized built-in gain is in- 
applicable unless the amount of net unrealized built-in gain ex- 
ceeds 25 percent of the value of the corporation's assets. Also, the 
definition is applied without taking account of any cash, cash 
items, or marketable security with a value that does not substan- 
tially differ from adjusted basis. 

The section 382 limitation is increased by the excess of (1) gain 
recognized by reason of an election under section 338, over (2) the 
portion of such gain taken into account in computing recognized 
built-in gains for a taxable year. A recognized built-in gain is any 
gain recognized during the recognition period on the disposition of 
any asset, if the corporation establishes that the asset was held im- 
mediately before the ownership change, and to the extent the gain 
does not exceed the excess of the asset's fair market value over the 
adjusted basis on such date. 

If an ownership change occurs during a taxable year, the section 
382 limitation does not apply to the utilization of losses against the 
portion of the corporation's taxable income allocable to the period 
before the change. For this purpose, except as provided in regula- 
tions, taxable income realized during the taxable year is allocated 
ratably to each day in such year. Under the allocation rule, taxable 
income is computed without regard to recognized built-in gains and 
losses. 

Explanation of Provision 

The bill clarifies that if a section 338 election is made, the sec- 
tion 382 limitation for the taxable year is increased by the lesser of 
the amount of net unrealized built-in gain (determined as of the 
time of the section 382 ownership change), not previously recog- 
nized, computed without regard to the 25-percent test, or the gain 
recognized by reason of section 338. 

Also, regarding the allocation rule for the taxable year in which 
an ownership change occurs, taxable income is computed without 
regard to recognized built-in gain or loss only if the corporation has 
a net unrealized built-in gain or loss. 

4. Testing period: Shorter period where all losses arise after three- 
year period begins (sec. 106(d)(4) of the bill, sec. 621 of the 
Reform Act, and sec. 382(i)(3) of the Code) 

Present Law 

The testing period for determining whether an ownership change 
has occurred generally is the three-year period preceding any 
owner shift involving a five-percent shareholder or any equity 
structure shift. After an ownership change, the testing period does 
not begin before the day following the first ownership change. If 
the corporation does not have a net unrealized built-in loss, the 
testing period does not begin before the first day of the first tax- 
able year from which there is a loss carryforward. 

Explanation of Provision 

The bill clarifies that the testing period does not begin before the 
earlier of (1) the first day of the first taxable year from which there 



35 

is a loss carryforward, or (2) the first day of the taxable year in 
which the transaction being tested occurs. Thus, where there is a 
current net operating loss for the taxable year in which an owner- 
ship change occurs, the testing period is determined by taking such 
taxable year into account. 

5. Definitions of loss corporation, old loss corporation, and new 
loss corporation (sec. 106(d)(5) of the bill, sec. 621(a) of the 
Reform Act, and sees. 382(k) and 382(1)(8) of the Code) 

Present Law 

The special limitations apply to the taxable income of any "new 
loss corporation." The term "loss corporation" is defined to include 
a corporation entitled to use a net operating loss carryover. A "new 
loss corporation" is a corporation that is a loss corporation after an 
ownership change. The same corporation may be both the old loss 
corporation and the new loss corporation. 

An "old loss corporation" is a corporation with respect to which 
there is an ownership change, which was a loss corporation before 
the ownership change, or with respect to which there is a pre- 
change loss. A pre-change loss is any net operating loss carryfor- 
ward of an old loss corporation to the taxable year ending with or 
in which the ownership change occurs, and the net operating loss 
of an old loss corporation for the taxable year in which the owner- 
ship change occurs (to the extent allocable to the period on or 
before the change date). 

In determining whether an ownership change has occurred, the 
percentage of stock in the new loss corporation is compared to the 
lowest percentage of stock in the old loss corporation (or any prede- 
cessor) owned by a shareholder during the testing period. 

Explanation of Provision 

The bill clarifies that the definition of a loss corporation includes 
a corporation entitled to use a pre-change loss (that is, a net oper- 
ating loss for the taxable year in which an ownership change 
occurs, as well as a net operating loss carryover to such year). 
Thus, for example, the definition of a new loss corporation includes 
a corporation that is entitled to use a net operating loss that was 
incurred in the taxable year in which an ownership change oc- 
curred. 

Except as provided in regulations, any entity and any predeces- 
sor or successor of such entity is treated as one entity. As an exam- 
ple, if a corporation purchases 100 percent of the stock of an unre- 
lated loss corporation, the loss corporation would become a new 
loss corporation. If the new loss corporation liquidates in a tax-free 
transaction pursuant to sections 332 (so the new loss corporation's 
net operating loss carryforwards carry over to the acquiring corpo- 
ration), the acquiring corporation — as successor — will continue to 
be treated as a new loss corporation. 



36 

6. Operating rules relating to ownership of stock (sec. 106(d)(6) of 
the bill, sec. 621(a) of the Reform Act, and sec. 382(1)(3) of the 
Code) 

Present Law 

In determining whether an ownership change has occurred, 
changes in the holding of certain preferred stock are disregarded, 
and the constructive ownership rules of section 318 are applied 
with several modifications. 

One modification to the rules of section 318 relates to options 
and similar interests. Except as provided in regulations, the holder 
of an option is treated as owning the underlying stock if such pre- 
sumption would result in an ownership change. Thus, the stock un- 
derlying an option or similar interest may be taken into account on 
and after the date on which the interest is acquired or later trans- 
ferred. The subsequent exercise of an option is disregarded if the 
holder of the option has been treated as owning the underlying 
stock. On the other hand, if the holder of an option was not treated 
as owning the underlying stock, the subsequent exercise will be 
taken into account in determining whether there is an owner shift 
at time of exercise. Similarly, except as provided in regulations, a 
person is treated as owning stock that may be acquired pursuant to 
any contingent purchase, warrant, convertible debt, put, stock sub- 
ject to a risk of forfeiture, contract to acquire stock, or similar in- 
terest, if such a presumption results in an ownership change.^ 

The Act does not provide rules for attributing stock that is 
owned by a government. For example, stock that is owned by a for- 
eign government is not treated as owned by any other person. 
Thus, if a government of a country owned 100 percent of the stock 
of a corporation and, within the testing period, sold all of such 
stock to members of the public who were citizens of the country, an 
ownership change would result. Governmental units, agencies, and 
instrumentalities that derive their powers, rights, and duties from 
the same sovereign authority will be treated as a single sharehold- 
er. 

Explanation of Provision 

The bill clarifies that the constructive ownership rules of section 
318 are applied only to "stock" that is taken into account for pur- 
poses of section 382. For example, assume a corporation owns both 
common stock and stock of a type that is not counted in determin- 
ing whether there has been an ownership change (referred to as 
"pure preferred") in a holding company. The pure preferred repre- 
sents 55 percent of the holding company's value. The holding com- 
pany's only asset consists of 100 percent of the common stock in an 
operating subsidiary that is a loss corporation. The sale of the pure 



^ Thus, the type of rights to acquire stock that are subject to the option rule may extend 
beyond tho:^ rights that have been treated as options under section 318(a)(4) as applied for other 
purposes. For example, a right to acquire unissued stock in a corporation would (except as pro- 
vided by regulations) be treated as exercised if an ownership change would result, without 
regard to how such right may have been treated under section 318(a)(4). The Treasury Depart- 
ment will exercise its regulatory authority to prevent the use of the option rule in appropriate 
cases — as one example, where options or similar interests are issued shortly after a corporation 
has incurred a de minimis amount of loss. 



37 

preferred would not constitute an ownership change because no 
stock in the loss corporation may be attributed through pure pre- 
ferred. On the other hand, assume 100 percent of the stock in a loss 
corporation is transferred in a section 351 exchange, in which the 
loss corporation's sole shareholder receives pure preferred repre- 
senting 51 percent of the transferee's value, and an unrelated 
party receives 100 percent of the transferee's common stock. Here, 
an ownership change would result with respect to the loss corpora- 
tion. Similar rules apply where a loss corporation is owned directly 
or indirectly by a partnership (or other intermediary) that has out- 
standing ownership interests substantially similar to a pure pre- 
ferred stock interest. 

The bill also clarifies that the rule with respect to options ex- 
tends beyond options that have been subject to section 318(a)(4). 

7. Bankruptcy proceedings (sec. 106(d)(7) of the bill, sec. 621(a) of 
the Reform Act, and sec. 382(1)(5) of the Code) 

Present Law 

The special limitations do not apply to an ownership change if 
the old loss corporation was under the jurisdiction of the court in a 
title 11 or similar case immediately before the ownership change, 
and the shareholders and creditors of the old loss corporation own 
50 percent or more of the value and voting power of the new loss 
corporation. A new loss loss corporation may elect to forgo this 
rule, in which case, the general rules will apply except the value 
used for purposes of computing the section 382 limitation will be 
the value of the new loss corporation immediately after the owner- 
ship change. 

A modified version of the bankruptcy exception applies to a 
thrift involved in an equity structure shift that is a reorganization 
described in section 368(a)(3)(D)(ii), or any other equity structure 
shift or transaction to which section 351 applies that occurs as an 
integral part of a transaction involving a reorganization described 
in section 368(a)(3)(D)(ii). The bankruptcy exception is applied to 
qualified thrift reorganizations by requiring shareholders, credi- 
tors, and depositors to retain a 20-percent (rather than 50-percent) 
interest. For this purpose, the fair market value of the outstanding 
stock in the new loss corporation includes deposits that become de- 
posits of the new loss corporation. 

Explanation of Provision 

The bill clarifies that, for purposes of the 50-percent test, stock of 
a shareholder is taken into account only to the extent such stock 
was received in exchange for stock or a qualified creditor's interest 
that was held immediately before the ownership change. Thus, for 
example, stock received by a former stockholder for new consider- 
ation, such as the provision of funds to the corporation, a guaran- 
tee of corporate obligations, or any other consideration, is not 
taken into account. Similarly, stock purchased from other stock- 
holders in the transaction is not counted. 

The bill also clarifies that if an election to forgo the bankruptcy 
rule is made, the value of the new loss corporation will reflect any 



increase in value resulting from the surrender or cancellation of 
creditors' claims in the transaction. 

Regarding qualified thrift reorganizations, the bill clarifies that 
the fair market value of the outstanding stock of the new loss cor- 
poration includes the amount of deposits in such corporation imme- 
diately after the change. Also, it is clarified that the voting power 
requirement will not cause a failure of the 20-percent test solely be- 
cause deposits do not carry adequate voting power. 

8. Effective dates (sec. 106(d)(10) of the bill and sec. 621(f) of the 
Reform Act) 

Present Law 

The provisions of the Act generally apply to ownership changes 
that occur on or after January 1, 1987. The Act states that its pro- 
visions apply to an ownership change following an owner shift in- 
volving a five-percent shareholder occurring after December 31, 
1986, or following an equity structure shift occurring pursuant to a 
plan of reorganization adopted after December 31, 1986. 

The earliest testing period under the Act begins on May 6, 1986. 
If an ownership change occurs after May 5, 1986, and before Janu- 
ary 1, 1987, and the provisions of the Act do not apply, then the 
earliest testing period will not begin before the day following the 
date of such ownership change. 

Under the general rules of section 382, if a public offering is per- 
formed by an underwriter on a "firm commitment" basis, the un- 
derwriter is treated as owning the stock for purposes of determin- 
ing whether an owner shift involving a 5-percent shareholder has 
occurred. 

The Act contains certain targeted transition provisions. 

Explanation of Provisions 

The bill clarifies that the provisions of the Act apply to owner- 
ship changes occurring after December 31, 1986. For purposes of 
this transition rule, and for purposes of determining when a new 
testing period starts under section 382(i), any equity structure shift 
pursuant to a plan of reorganization adopted before January 1, 
1987 is treated as occurring when such plan was adopted. ^^ 

By treating equity structure shifts pursuant to plans of reorgani- 
zation that were adopted before January 1, 1987 as occurring when 
the plan was adopted, the bill clarifies that no equity structure 
shift pursuant to a plan adopted after 1986, and no other owner 
shift involving a 5-percent shareholder occurring after 1986, is pro- 
tected under the transition provisions, even though such shifts may 
occur before the completion of a pre-1987 plan of reorganization; i.e., 
such shifts are not grandfathered by virtue of the pre-1987 plan. 
If however, an ownership change occurs within the testing period 
prior to the end of 1987 when any equity structure shift pursuant 
to a pre-1987 plan is considered together with other pre-1987 owner 
shifts, that ownership change is grandfathered and a new testing 



^"The bill thus clarifies that the transition rule for equity structure shifts pursuant to pre- 
1987 plans of reorganization is applicable even though such equity structure shift may also be 
an owner shift involving a 5-percent shareholder. 



39 

period starts. Any equity structure shift pursuant to a plan adopt- 
ed after 1986, and any post-1986 owner shift involving a 5-percent 
shareholder, that occurs before the completion of the pre-1986 plan 
of reorganization will count for purposes of determining when or 
whether a later ownership change occurs, under section 382(i). 

If, applying the foregoing provisions and the rule in section 
382(1)(3) (described below), an ownership change occurs immediately 
following an equity structure shift pursuant to a post-1986 plan of 
reorganization, or immediately following any other post-1986 owner 
shift involving a 5-percent shareholder the ownership change is 
subject to the provisions of section 382 as amended by the Act. 

The bill clarifies that the May 6, 1986 testing date applies for 
purposes of determining whether an ownership change occurred 
after May 5, 1986 and before January 1, 1987. For purposes of de- 
termining whether shifts in ownership occurred between May 5, 
1986, and January 1, 1987, the rule in section 382(1)(3) for options 
and similar interests applies. Thus, in the case of such an interest 
issued on or after May 6, 1986, and before January 1, 1987, the un- 
derlying stock could be treated as acquired at the time the interest 
was issued. For this transition period, however, in addition to the 
Treasury Department's general regulatory authority under the 
rule in section 382(1)(3), the Treasury Department may provide for 
different treatment in the case of an acquisition of an option or 
similar interest that is not in fact exercised, as appropriate where 
the effect of treating the underlying stock as if it were acquired 
would be to cause an ownership change that would start a new 
testing period (and thus result in relief under the transitional 
rules). No inference is intended as to how pre-May 6, 1986 options 
or similar interests would be treated. 

The 1954 Code version of section 382 has continuing application 
to any increase in percentage points to which the provisions of the 
Act do not apply by reason of any transitional rule — including the 
rules prescribing measurement of the testing period by reference 
only to transactions after May 5, 1986, and the rules that disregard 
ownership changes following or resulting from certain transactions. 

Unless the corporation elects otherwise, an underwriter of an of- 
fering for a corporation before September 19, 1986, will not be 
treated as having acquired stock in the corporation by reason of a 
firm commitment underwriting, to the extent the stock is disposed 
of pursuant to the offering, but no later than 60 days after the ini- 
tial offering. 

Any regulations that have the effect of treating a group of share- 
holders as a separate five-percent shareholder by reason of a public 
offering will not apply to institutions described in section 591, for 
any period before January 1, 1989. Further, an underwriter of any 
offering for such an institution will not be treated as acquiring 
stock in the institution by reason of a firm commitment underwrit- 
ing, but only to the extent such stock is disposed of no later than 
60 days after the initial offering and pursuant to the offering. 

The bill makes certain corrections to specific targeted transition 
provisions. 



40 

E. Recognition of Gain or Loss on Liquidating Sales and 
Distributions of Property {General Utilities) 

1. Limitations on recognition of loss (sees. 106(e)(1) and (2) of the 
bill, sec. 631(a) of the Reform Act, and sees. 336(d)(2) and 
336(d)(3) of the Code) 

Present Law 

A corporation generally recognizes gain or loss on a sale or dis- 
tribution of property, whether or not in liquidation. However, 
under the statute, loss is not recognized in certain circumstances 
{see, e.g., sec. 336(d)). ^ One circumstance in which loss is not recog- 
nized involves the sale, exchange or distribution of property ac- 
quired by a liquidating corporation in a transaction to which sec- 
tion 351 applied or as a contribution to capital, if the acquisition of 
such property was part of a plan a principal purpose of which was 
to recognize loss by the liquidating corporation in connection with 
the liquidation. In these circumstances, the basis of the property 
for purposes of determining loss is reduced, but not below zero, by 
the excess of the adjusted basis of the property on the date of con- 
tribution over its fair market value on such date.^ The statute pro- 
vides that if the adoption of a plan of complete liquidation occurs 
in a taxable year following the date on which the tax return in- 
cluding the loss disallowed by this provision is filed, the Secretary 
may prescribe regulations under which the loss may be recaptured 
in the year of liquidation, rather than requiring an amended 
return to be filed with respect to the year the loss was taken. The 
Act provides that property acquired by the liquidating corporation 
during the two-year period ending on the date of the adoption of 
the plan of liquidation shall, except as provided in regulations, be 
treated as part of such a plan subject to these provisions.® 



^ Congress did not intend to create any inference regarding the deductibility of losses in liqui- 
dating or nonliquidating distributions or sales under other statutory provisions or judicially cre- 
ated doctrines, or to preclude the application of such provisions or doctrines where appropriate 
See, e.g., sec. 482 and Treas. Reg. sec. 1.482-l(d)(5); National Securities Corp. Comm'r, 46 B.T.A. 
562 (1942), cert, denied 320 U.S. 794 (1943) (loss on sale by subsidiary of securities transferred by 
parent in nonrecognition transaction reallocated to parent, where purpose of transfer was to 
shift unrealized loss on securities to subsidiary); Court Holding Co. v. U.S., 324 U.S. 321 (1945) 
(corporation treated as true seller of property distributed to shareholders and purportedly sold 
by them to third party); and Gregory v. Helvering, 293 U.S. 465 (1935) (in addition to meeting 
literal requirements of statute, transaction must have valid business purpose to qualify for non- 
recognition). 

' The effect of this rule of section 336(d)(2) is to deny recognition to the liquidating corporation 
of that portion of the loss on the property that accrued prior to the contribution, but to permit 
recognition of any loss accruing after the contribution. In the event that a transaction is de- 
scribed both in section 336(d)(1) (which denies loss accruing either before or after the contribu- 
tion) and section 336(d)(2), section 336(d)(1) will prevail. 

This provision was not intended to override section 311(a). Thus, if property is distributed in a 
nonliquidating context, the entire loss (and not merely the built-in loss) will be disallowed. 

* Although Congress recognized that a contribution more than two years before the adoption 
of a plan of liquidation might have been made for such a tax-avoidance purpose. Congress also 
recognized that the determination that such purpose existed in such circumstances might be dif- 
ficult for the Internal Revenue Service to establish and therefore as a practical matter might 
occur infrequently or in relatively unusual cases. 

Congress intended that the Treasury Department will issue regulations generally providing 
that the presumed prohibited purpose for contributions of property within two years of the 
adoption of a plan of liquidation will be disregarded unless there is no clear and substantial 
relationship between the contributed property and the conduct of the corporation's current or 
future business enterprises. 

Continued 



41 

In the case of any liquidation to which section 332 of the Code 
applies, the Act provides that no loss shall be recognized in such 
liquidation. 

Explanation of Provision 

The bill clarifies that an acquisition of property by a corporation 
after the date two years before the date the corporation adopts a 
plan of complete liquidation (rather than merely during the two- 
year period ending on the date of the adoption of the plan) shall, 
except as provided in regulations, be treated as acquired as part of 
a plan a principal purpose of which was to recognize loss by the 
liquidating corporation in connection with the liquidation. 

The bill also clarifies that the provision denying recognition of 
loss to the distributing corporation in a section 332 liquidation is 
intended to apply to a distribution to the corporation meeting the 
control requirement of section 332 only if the distribution does not 
result in gain recognition to the distributing corporation, pursuant 
to section 337(a) or (b)(1). Thus, the provision denies loss recogni- 
tion on a taxable distribution to minority shareholders in such a 
liquidation. If the section 332 liquidation is not described in section 
337(b)(1) or (2) (for example, in the case of certain liquidations into 
a tax exempt parent corporation) the special loss disallowance pro- 
vision of section 336(d)(3) does not apply. Such a transaction would 
be subject to any other applicable loss disallowance provisions, 
however. 

2. Election to treat certain stock sales and distributions as asset 
transfers (sec. 106(e)(3) of the bill, sec. 631(a) of the Reform 
Act, and sec. 336(e) of the Code) 

Present Law 

Under regulations prescribed by the Secretary, a corporation 
may elect to treat certain sales and distributions of subsidiary 
stock as asset transfers. 



A clear and substantial relationship between the contributed property and the conduct of the 
corporation's business enterprises would generally include a requirement of a corporate business 
purpose for placing the property in the particular corporation to which it was contributed, 
rather than retaining the property outside the corporation. If the contributed property has a 
built-in loss at the time of contribution that is significant in amount as a proportion of the built- 
in corporate gain at that time, special scrutiny of the business purposes would be appropriate. 

Congress expected that such regulations will permit the allowance of any resulting loss from 
the disposition of any of the assets of a trade or business (or a line of business) that are contrib- 
uted to a corporation where prior law would have permitted the allowance of the loss and the 
clear and substantial relationship test is satisfied. In such circumstances, application of the loss 
disallowance rule is inappropriate assuming there is a meaningful (i.e., clear and substantial) 
relationship between the contribution and the utilization of the particular corporation form to 
conduct a business enterprise. If the contributed business is disposed of immediately after the 
contribution it is expected that it would be particularly difficult to show that the clear and sub- 
stantial relationship test was satisfied. Congress also anticipated that the basis adjustment rules 
will generally not apply to a corporation's acquisition of property as part of its ordinary start-up 
or expansion of operations during its first two years of existence. However, if a corporation has 
substantial gain assets during its first two years of operation, a contribution of substantial built- 
in loss property followed by a sale or liquidation of the corporation would be expected to be 
closely scrutinized. 



42 

Explanation of Provision 

The bill clarifies that Congress did not intend to require the elec- 
tion to be made unilaterally by the selling or distributing corpora- 
tion. The bill thus provides that under regulations prescribed by 
the Secretary, an election may be made to treat the certain sales 
and distributions of subsidiary stock as asset sales. Compare sec- 
tion 338(h)(10). 

3. Treatment of distributing corporation where the 80-percent dis- 
tributee is a tax-exempt organization (sec. 106(e)(4) of the bill, 
sec. 631(a) of the Reform Act, and sec. 337(b)(2) of the Code) 

Present Law 

Gain or loss is generally not recognized to the distributing corpo- 
ration on certain distributions to a corporate parent that is an 80- 
percent distributee. However, if the 80-percent distributee is a tax- 
exempt organization, this rule does not apply unless the organiza- 
tion uses the property in an unrelated trade or business. Further- 
more, if the organization does so use the property but subsequently 
disposes of the property or otherwise ceases to use it in an unrelat- 
ed business, such disposition or cessation is a taxable event. 

Explanation of Provision 

The bill clarifies that the provision with respect to use in an un- 
related trade or business was intended to apply to use in an activi- 
ty the income from which is subject to tax under section 511(a). ^ 

4. Basis adjustment in taxable section 332 liquidation (sec. 

106(e)(6) of the bill and sec. 334 of the Code) 

Present Law 

A liquidating corporation recognizes gain or loss on certain liqui- 
dating distributions to which the rule of section 332(a) applies — for 
example, certain distributions to a tax-exempt or a foreign corpora- 
tion. 

Explanation of Provision 

The bill clarifies that if gain is recognized on a distribution of 
property in a liquidation described in section 332(a) to a corporate 
distributee meeting the stock ownership requirements of section 
332(b), a corresponding increase in the distributee's basis occurs. 



® A distribution to a charitable trust would not qualify as a distribution to an 80-percent dis- 
tributee (since only a corporation can qualify as an 80-percent distributee). Accordingly, the bill 
deletes the reference to section 511(b)(2) in section 337(b)(2). 



43 

5. Use of installment method by shareholders in certain liquida- 

tions (sec. 106(e)(6) of the bill, sec. 631(a) of the Reform Act, 
and sec. 453(h)(1)(B) of the Code) 

Present Law 

The Act retained prior law in providing that if, in a liquidation 
to which section 331 applies, the shareholder receives, in exchange 
for such shareholder's stock, certain installment obligations ac- 
quired by the corporation in respect of certain sales or exchanges 
of property, the receipt of payments under such an obligation by 
the shareholder shall be treated as the receipt of payment for the 
stock. 

Explanation of Provision 

The bill clarifies that, as under the law prior to the enactment of 
the Act, in the case of inventory the corporate sale or exchange 
must have been not only to one person but to one person in one 
transaction. 

6. Certain distributions of partnership or trust interests (sec. 

106(e)(7) of the bill, sec. 631 of the Reform Act, and sees. 386 
and 311 of the Code) 

Present Law 

Under the Act, a corporation generally recognizes gain or loss on 
a liquidating distribution of property as if the corporation had sold 
the property to the distributee. A corporation also generally recog- 
nizes gain or loss on liquidating sales of property. Gain but not loss 
is generally recognized on a nonliquidating distribution. Distribu- 
tions of partnership interests are thus also treated as sales, invok- 
ing the provisions of section 751 of the Code. A separate provision 
(sec. 386) also provides for the treatment of certain sales and distri- 
butions of partnership interests by corporations. 

Explanation of Provision 

The bill generally repeals section 386 of the Code as deadwood in 
light of the Act's amendments to sections 311, 336 and 337 of the 
Code. However, the bill restates, in section 311, the provision con- 
tained in present law section 386(d), that the Secretary may by reg- 
ulations provide that the amount of gain recognized on a nonliqui- 
dating distribution of a partnership interest shall be computed 
without regard to any loss attributable to property contributed to 
the partnership for the principal purpose of recognizing such loss 
on the distribution (i.e., thereby reducing the gain otherwise recog- 
nized on the distribution and effectively recognizing a loss not per- 
mitted in a nonliquidating distribution). ^ ° 



^° This provision is not intended to limit the operation of any present-law step-transaction or 
other doctrines that would disregard such loss. Such doctrines would also apply if a corporation 
with property on which loss would be disallowed under other Code provisions (such as sections 
336(d)(1) or (d)(2)) contributed such property to a partnership to reduce the gain on distribution 
of the partnership interest and thus indirectly recognize the loss. 



44 

7. Losses on transactions between related taxpayers (sec. 106(e)(8) 

of the bill, sec. 631 of the Reform Act, and sec. 267 of the 
Code) 

Present Law 

No loss is generally allowed with respect to the sale or exchange 
of property between related taxpayers (other than a loss in case of 
a distribution in corporate liquidation) (sec.267(a)). The Act provid- 
ed that certain losses at the corporate level may be denied in a liq- 
uidation under other Code provisions (sec. 336(d)). 

Explanation of Provision 

The bill clarifies that section 267(a) does not apply either to any 
loss of the distributee or to any loss of the distributing corporation 
in the case of a distribution in complete liquidation. Losses may be 
denied under other provisions of law or judicially created doctrine 
as under present law. 

8. Distributions of property to corporate shareholders (sees. 

106(e)(9), (10) and (11) of the bill, sec. 631 of the Reform Act, 
and sec. 301 of the Code) 

Present Law 

Section 301 of the Code provides generally that, in the case of a 
corporate distribution of property to a corporate distributee, the 
amount distributed is the lesser of (1) the fair market value of the 
property or (2) the adjusted basis of the property in the hands of 
the distributee, increased in the amount of gain recognized to the 
distributing corporation on the distribution. The basis of the prop- 
erty in the hands of the distributee is the same as the amount dis- 
tributed. 

If gain is recognized to the distributing corporation on a nonli- 
quidating distribution, the holding period of the property in the 
hands of the distributee begins on the date of the distribution. 

The Act provided that, on a nonliquidating distribution of prop- 
erty to a shareholder (including to a corporate shareholder), gain 
(but not loss) is recognized to the distributing corporation as if the 
property had been sold to the distributee at fair market value. On 
a liquidating distribution, gain or loss is generally recognized 
(though loss is not recognized in certain instances). Provisions of 
the Code other than section 301 generally provide for the basis of 
property received in a liquidation (sees. 331 and 334). 

Explanation of Provision 

Certain portions of section 301 are repealed as deadwood. Thus, 
section 301 of the Code is amended to provide that the amount dis- 
tributed and the basis of property in the hands of a corporate dis- 
tributee is the fair market value of the property. The holding 
period of such distributed property in the hands of the distributee 
begins on the date of the distribution, as under present law, but 
section 301(e) is not necessary to reach this result and is repealed. 



45 

9. Certain transfers to foreign corporations (sec. 106(e)(12) of the 

bill, sec. 631(d) of the Reform Act, and sees. 367(a) and 
367(e)(2) of the Code) 

Present Law 

Gain is recognized to a liquidating corporation in the case of a 
liquidating distribution to an 80-percent distributee that is a for- 
eign corporation, unless regulations provide otherwise. It is expect- 
ed that such regulations may permit nonrecognition if the poten- 
tial gain on the distributed property at the time of the distribution 
is not being removed from the U.S. taxing jurisdiction prior to rec- 
ognition. 

Explanation of Provision 

The bill clarifies that a tax-free reorganization transfer of prop- 
erty to a foreign corporation is treated in the same manner as a 
liquidating transfer of such property to an 80-percent foreign corpo- 
rate distributee. Thus, the provisions of section 367(a)(2) and (3) do 
not apply, and gain is recognized on a transfer of property de- 
scribed in section 361(a) or (b) (as amended by the bill) by a U.S. 
corporation to a foreign corporation, unless regulations provide oth- 
erwise. However, subject to such basis adjustments as shall be pro- 
vided in regulations, this rule does not apply if the foreign corpo- 
rate transferee is 80-percent controlled (within the meaning of sec- 
tion 368(c)) by a domestic corporation or by members of the same 
affiliated group of corporations within the meaning of section 1504. 
It is expected that regulations will provide this relief only if the 
U.S. corporate shareholder agrees to take a basis in the stock it re- 
ceives in a foreign corporation that is a party to the reorganization 
equal to the lesser of (a) the U.S. corporation's basis in such stock 
received pursuant to section 358, or (b) its proportionate share of 
the basis in the assets of the transferor corporation transferred to 
the foreign corporation. U.S. taxing jurisdiction over the built-in 
gain in such cases of U.S. corporate control is indirectly retained 
through the provisions of the Code relating to controlled foreign 
corporations. The requirement that certain U.S. corporate share- 
holders own at least 80 percent of the CFC stock assures that the 
bulk of the built-in gain will remain subject to U.S. taxing jurisdic- 
tion and justifies not imposing a partial tax on the portion of the 
gain not attributable to U.S. corporate shareholders. (Such a par- 
tial tax could present administrative difficulties in adjusting the 
basis of property in the hands of the transferee foreign corpora- 
tion.) 

10. Gain from certain sales or exchanges of stock in certain for- 
eign corporations (sec. 106(e)(13) of the bill, sec. 631(d) of the 
Reform Act, and sec. 1248 of the Code) 

Present Law 

Gain from certain sales or exchanges of stock in certain foreign 
corporations is characterized as a dividend to the recipient under 
section 1248 of the Code. Section 1248(f) contains various provisions 
that under prior law caused income recognition and dividend treat- 



46 

ment where a U.S. corporation sold, exchanged, or distributed the 
stock of a foreign corporation and gain and earnings and profits 
would not have occurred. This recognition was necessary because 
prior law treated certain liquidating sales and distributions and 
certain nonliquidating distributions by corporations as nonrecogni- 
tion events. 

Section 1248(d)(2) also contains a provision that was intended to 
assure that a foreign corporation that sold property in a liquidation 
would not experience an increase in earnings and profits to the 
extent that gain would not be recognized under section 337(a) of 
the Code on such a sale. This provision was originally written with 
reference to prior law section 337(a), which was repealed by the 
Act. 

Under the Act, a distributing corporation generally recognizes 
gain on a liquidating or nonliquidating distribution of property 
with a fair market value in excess of basis as if the property dis- 
tributed had been sold to the distributee at fair market value, and 
earnings and profits of the distributing corporation are accordingly 
increased. There are certain exceptions in the case of distributions 
that would be tax-free to a recipient under the tax-free reorganiza- 
tion provisions of the Code or under section 355 of the Code, and in 
the case of certain liquidating distributions to an 80-percent corpo- 
rate distributee. 

Explanation of Provisions 

The bill amends section 1248(f) to conform to the changes under 
the Act that generally cause gain to be recognized, and earnings 
and profits to be created, on a liquidating sale or distribution or on 
a nonliquidating distribution, and that treat liquidating and nonli- 
quidating distributions as sales or exchanges for this purpose. Sec- 
tion 1248(f)(1) under the bill applies only to certain distributions 
that are still nonrecognition events to the distributing corporation 
and are not treated as a sale by such corporation to the distribu- 
tee — that is, distributions that would be tax-free to the recipient 
under the reorganization provisions of section 361(c) of the Code (as 
amended by the bill) or under section 355 of the Code and certain 
liquidating distributions to an 80-percent distributee. As under 
present law, section 1248(f)(2) excepts those situations in which the 
recipient U.S. corporation satisfies the stock ownership require- 
ments of section 1248(f)(2) and is treated as holding stock for the 
period the stock was held by the distributing corporation. 

It is contemplated that the Treasury Department may exercise 
its regulatory authority under section 1248(f) to provide that, in 
cases where a distribution that would be tax-free but for section 
1248(f)(1) occurs within a controlled group, and section 1248(f)(2) 
does not otherwise apply, the recipient corporation may be re- 
quired to take a carryover basis in the stock received (rather than 
a substituted basis under section 358, for example, in the case of a 
section 355 or 361 distribution) and section 1248(f)(1) will not apply 
to such distribution. 

The bill repeals sections 1248(f)(3) and 1248(d)(2) as deadwood. 

The bill makes certain other related clerical and conforming 
amendments. 



47 

11. Tax imposed on certain built-in gains of S corporations (sec. 
106(f) of the bill, sec. 632 of the Reform Act, and sec. 1374 of 
the Code) 

Present Law 

A corporate level tax is imposed on gain that arose prior to the 
conversion of a C corporation to an S corporation C*built-in gain") 
that is recognized by the S corporation through sale, distribution, 
or other disposition within 10 years after the date on which the S 
election took effect. The total amount of gain that must be recog- 
nized by the corporation, however, is limited to the aggregate net 
built-in gain of the corporation at the time of conversion to S 
status. 

The Act provided that the amount of recognized built-in gains 
taken into account for any taxable year shall not exceed the excess 
(if any) of 1) the net unrealized built-in gain, over 2) the recognized 
built-in gains for prior years beginning in the 10-year recognition 
period. 

Under the Act, the corporation may take into account certain 
subchapter C tax attributes in computing the amount of tax on rec- 
ognized built-in gains. Thus, for example, it may use unexpired net 
operating losses to offset the gain and may use business credit car- 
ryforwards to offset the tax. 

Explanation of Provision 

The bill clarifies that the built-in gain provision applies not only 
when a C corporation converts to S status but also in any case in 
which an S corporation acquires an asset and the basis of such 
asset in the hands of the S corporation is determined (in whole or 
in part) by reference to the basis of such asset (or any other proper- 
ty) in the hands of the C corporation. In such cases, each acquisi- 
tion of assets from a C corporation is subject to a separate determi- 
nation of the amount of net built-in gain, and is subject to the pro- 
vision for a separate 10-year recognition period. 

The bill clarifies that the amount of recognized built in gains 
taken into account for any taxable year shall not exceed the excess, 
if any, of 1) the net unrealized built-in gains at the time of the con- 
version, over 2) the recognized built-in gains for prior years begin- 
ning in the recognition period to the extent such gains were subject 
to the built-in gains tax. 

The bill clarifies that, for purposes of this built-in gains tax 
under section 1374, any item of income which is properly taken 
into account for any taxable year in the recognition period but 
which is attributable to periods before the first taxable year for 
which the corporation was an S corporation is treated as a recog- 
nized built-in gain for the taxable year in which it is properly 
taken into account. Thus, the term "disposition of any asset" in- 
cludes not only sales or exchanges but other income recognition 
events that effectively dispose of or relinquish a taxpayer's right to 
claim or receive income. For example, the term "disposition of any 
asset" for purposes of this provision also includes the collection of 
accounts receivable by a cash method taxpayer and the completion 



48 

of a long-term contract performed by a taxpayer using the complet- 
ed contract method of accounting. 

The bill clarifies that capital loss carryforwards may also be used 
to offset recognized built-in gains. 

The bill makes certain other clerical and conforming changes. 

12. Regulatory authority to prevent circumvention of provisions 
(sec. 106(e)(5) of the bill, sec. 631 of the Reform Act, and sec. 
337(d) of the Code) 

Present Law 

The Act provided that the Treasury Department shall prescribe 
such regulations as may be necessary or appropriate to carry out 
the purposes of the amendments made to Subpart B of the Code 
under the Act, including regulations to ensure that such purposes 
may not be circumvented through the use of any provision of law 
or regulations, including the consolidated return regulations and 
Part III of the Code, dealing with corporate organizations and tax- 
free reorganizations. 

Explanation of Provision 

The bill clarifies that the Treasury Department shall also pre- 
scribe such regulations as may be necessary or appropriate to carry 
out the purposes of the built-in gain provisions, including the use of 
such pass-through entities, other than S corporations, as regulated 
investment companies (RICs) or real estate investment trusts 
(REITs). For example, this includes rules to require the recognition 
of gain if appreciated property of a C corporation is transferred to 
a RIC or a REIT in a carryover basis transaction that would other- 
wise eliminate corporate level tax on the built-in appreciation. 

It is expected that Treasury shall also prevent the avoidance of 
the section through contributions of property with built-in loss to a 
corporation before it becomes an S corporation. 

13. Transition provisions (sec. 106(g) of the bill and sec. 633 of the 

Reform Act) 

a. Built-in gains of S corporations (sec. 106(g)(1) of the bill 
and sec. 633(b) of the Reform Act) 

Present Law 

The provisions of the Act (new Code section 1374) that impose a 
corporate level tax on certain built-in gains of C corporation assets 
after conversion to S status do not apply unless the first taxable 
year for which the former C corporation is an S corporation is pur- 
suant to an election made after December 31, 1986. Prior law sec- 
tion 1374 will apply if Code section 1374 as amended by the Act 
does not apply. 

Explanation of Provision 

The bill clarifies that, for purposes of the transition provisions, if 
a corporation was a C corporation at any time prior to December 
31, 1986, any "S" status of such corporation prior to its "C" corpo- 



49 

ration status is disregarded. Thus, the bill provides that (subject to 
the special small corporation transition rules of the Act) the built- 
in gains provisions apply to taxable years beginning after Decem- 
ber 31, 1986, in cases where the return for the taxable year is filed 
pursuant to an S election made after December 31, 1986. 

The bill clarifies that a 34-percent tax rate applies to capital gain 
that is subject to prior law section 1374 in taxable years beginning 
after December 31, 1986. 

b. General transition rule based on pre- August 1, 1986 

action (sec. 106(g)(2) of the bill and sec. 633(c)(1)(B) of 
the Reform Act) 

Present Law 

The statute states that the amendments made by the Act do not 
apply to distributions or sales or exchanges by a corporation if 50 
percent or more of the voting stock by value of such corporation is 
acquired on or after August 1, 1986, pursuant to a written binding 
contract in effect before such date and if such corporation is com- 
pletely liquidated before January 1, 1988. The conference report 
states that this transition rule applies if "a majority" of the voting 
stock was acquired pursuant to such binding written contract. 

Explanation of Provision 

The bill clarifies that the transition rule applies if more than 50 
percent (rather than 50 percent or more) of the voting stock is ac- 
quired pursuant to the binding written contract. 

c. Transitional rules for certain small corporations (sees. 

106(g)(3) through 106(g)(8) of the bill and sec. 633(d) of 
the Reform Act) 

Present Law 

Special delayed effective dates are provided under the Act for 
certain closely held corporations that are limited in size. Corpora- 
tions eligible for this rule are generally entitled to prior-law treat- 
ment with respect to liquidating sales and distributions occurring 
before January 1, 1989, provided the liquidation is completed before 
that date. However, the special transitional rule requires the recog- 
nition of income on distributions of ordinary income property and 
short-term capital gain property. The statute states that recogni- 
tion is also required with respect to any gain to the extent section 
453B of the Code applies. 

The Act provides that a corporation eligible for this rule may 
also become an S corporation for a taxable year beginning before 
January 1, 1989. In such a case, the corporation is not subject to 
the new rules of section 1374 relating to built-in gains except with 
respect to ordinary income and short-term capital gain property. ^^ 



' ' However, a corporation having a value in excess of $5 million (but not in excess of $10 mil- 
lion) is subject to a phase-out of this relief. Thus, in such circumstances new section 1374 applies 
to a portion of the long-term capital gain. Section 1374 as in effect before the Act will apply to 
any portion of the built-in long term capital gains not subject to new section 1374. In addition, 

Continued 



73-917 0-87-3 



50 

The Act repealed section 333 of the Code. However, the amend- 
ments made by the Act do not apply to the applicable percentage of 
each gain or loss which would otherwise be recognized by reason of 
the Act. The applicable percentage is 100 percent if the applicable 
value of the qualified corporation is less than $5 million, and 
phases down to percent if the applicable value of the corporation 
exceeds $10 million. 

For distributions prior to January 1, 1989, qualifying corpora- 
tions continue to be eligible for relief under the rules relating to 
nonliquidating distributions in effect prior to the Act (prior law 
sec. 311(d)(2)). However, this relief does not apply to distributions of 
ordinary income property or short-term capital gain property. 

The Act provides that a corporation is eligible for these special 
delayed effective dates if it was in existence on August 1, 1986, its 
value does not exceed $10 million, and more than 50 percent (by 
value) of the stock is held by 10 or fewer qualified persons. The 
conference report states that such 10 or fewer qualified persons 
must have held their stock for five years or longer. 

The Act provides that a qualified person is an individual, an 
estate, or any trust described in clause (ii) or (iii) of section 
1361(c)(2)(A) of the Code. Specified attribution rules are provided 
for purposes of determining ownership. 

The Act provides that all members of the same controlled group 
(as defined in section 267(f)(1) of the Code) are treated as one corpo- 
ration for purposes of the small corporation transitional rules. 

The Act provides that the small corporation transition rules 
shall also apply in the case of a transaction described in section 338 
of the Code where the section 338 acquisition date is before Janu- 
ary 1, 1989. 

Explanation of Provision 

The bill clarifies that a qualified corporation eligible for the spe- 
cial delayed effective dates does not recognize gain on a distribu- 
tion of installment obligations that are received in exchange for 
long-term capital gain property (including section 1231 property 
the disposition of which would produce long-term capital gain) 
where the distribution of such obligations would not have caused 
corporate level recognition under sections 337 and 453B(d)(2) as in 
effect prior to the Act. However, distributions of such installment 
obligations received in exchange for ordinary income property or 
short-term capital gain property do require the recognition of cor- 
porate level gain. 

It is intended that a taxpayer that purchases the stock of a quali- 
fied corporation in a qualified stock purchase prior to January 1, 
1989, is entitled to apply prior-law rules (modified as in the case of 
actual liquidations) with respect to an election under section 338, 
even though in the hands of the acquiring corporation the qualified 
corporation no longer satisfies the stock holding period require- 
ments and may not satisfy the size or shareholder requirements 
due to the size or shareholders of the acquiring corporation. 



to the extent a corporation is eligible for relief under the small corporation rule, a portion of 
any other long-term capital gain that would be covered by prior law section 1374 (whether or 
not built-in at the time of conversion) continues to be covered by that section. 



51 

The bill clarifies that, although the Act repealed section 333 of 
the Code, in the case of a liquidating distribution to which section 
333 of prior law would apply, a shareholder of a qualified corpora- 
tion electing such treatment is entitled to apply section 333 with- 
out any phase-out of shareholder level relief under the Act. Howev- 
er, an increase in shareholder-level gain could result from an in- 
crease in corporate earnings and profits resulting from application 
of the corporate-level phase-out of relief. 

The bill clarifies that for distributions before January 1, 1989, 
qualifying corporations continue to be eligible for relief under 
prior-law rules relating to nonliquidating distributions with respect 
to qualified stock, (prior law sec. 311(d)(2)), without regard to 
whether the corporation liquidates before January 1, 1989. Howev- 
er, this relief does not apply to distributions of ordinary income 
property or short-term capital gain property. 

The bill clarifies that a corporation is not a qualified corporation 
unless more than 50 percent (by value) of the stock of such corpora- 
tion is owned (on August 1, 1986 and at all times thereafter before 
the corporation is completely liquidated) by the same 10 or fewer 
qualified persons who at all times during the 5-year period ending 
on the date of the adoption of the plan of liquidation (or, if shorter, 
the period during which the corporation or any predecessor was in 
existence) owned (or were treated as owning under the attribution 
rules) more than 50 percent (by value) of the stock of such corpora- 
tion. 

Where stock passes to an estate, the holding period of the estate 
includes that of the decedent. Also, the "look-through" attribution 
rules that apply under this provision do not apply in the case of 
trusts qualifying under section 1361(c)(2)(ii) or (iii), just as they do 
not apply under the Act in the case of estates. Thus, stock held by 
such entities, like stock held by an estate, is to be treated as held 
by a single qualified person, so that the 10-shareholder test will not 
cease to be satisfied merely because a decedent's stock passes to 
such a trust. (In the case of other trusts holding stock, the "look- 
through" attribution rules apply to determine whether more than 
10 qualified persons ultimately own the stock). 

The bill also clarifies that the holding period of a decedent's 
estate (or a section 1361(c)(2)(A)(ii) or (iii) trust) is tacked with that 
of any beneficiary, as well as with that of the decedent, for pur- 
poses of determining the holding period. However, except in the 
case of beneficiaries who are treated as being "one person" with 
the decedent, once stock has been distributed to beneficiaries, the 
10-shareholder requirement might fail to be satisfied due to an in- 
crease in the number of shareholders. 

In the case of indirect ownership through an entity, the rules de- 
scribed above are the only rules that apply to determine ownership 
and holding period. Thus, it is not intended that holding periods 
could otherwise be "bootstrapped" through analogy to or applica- 
tion of any provision of section 1223. For example, if a partnership 
owns all the stock of a corporation, a new partner who contributes 
other property to the partnership in exchange for a partnership in- 
terest is deemed under section 1223 to have a holding period in the 
partnership interest that includes such person's holding period for 
the property contributed. However, such a person would not be 



52 

deemed thereby to have owned stock in the corporation that the 
partnership owned for any period prior to the time the person 
became a partner. In such cases, under the attribution and other 
holding period rules of the transitional provision a qualified per- 
son's holding period for the underlying stock is the lesser of (1) the 
period during which the entity held the stock in the qualified cor- 
poration, or (2) the period during which the qualified person held 
the interest in the entity. In other situations, the basic attribution 
and holding period rules of the transitional rule provision may pro- 
vide a different result. ^ ^ 

The bill clarifies that the rule that all members of a controlled 
group of corporations (as defined in section 267(f)(1)) are treated as 
a single corporation applies solely for purposes of determining 
whether the corporation meets the size requirements for relief. 
Thus, it is clarified that it is not necessary for all members of a 
group that, in the aggregate, meets the size requirements for a 
qualified corporation, to liquidate before January 1, 1989, in order 
for the liquidation of one member of the group to qualify for relief. 
It is not intended that an S corporation be included as a member of 
the group unless such corporation was a C corporation for its tax- 
able year including August 1, 1986 or was an S corporation that 
was not described in section 1374(c)(1) or (2) of prior law for such 
taxable year. 

The bill also provides a rule to prevent the use of qualified corpo- 
rations as conduits for the sale of assets by corporations that are 
not qualified. It is expressly provided that the transition rules do 
not apply where a principal purpose of a carryover basis transfer of 
an asset to a qualified corporation is to secure the benefits of the 
special transition rules. This provision is not intended to limit the 
application of the step transaction doctrine or other doctrines that 
would prevent the use of the transition rules. It is expected that a 
similar step transaction approach would be applied in the case of 
any transfer of assets to any corporation that qualified for transi- 
tion under any of the other provisions of the Act, if a principal pur- 
pose of the transfer was to secure the benefit of transition for an 
otherwise non-qualified transaction. 

The bill makes certain other clerical and conforming changes. 

d. Other transitional rules (sees. 106(g)(9) through 
106(g)(12) of the bill and sees. 633(f)(2), (3), (4), and (5) 
of the Reform Act) 

Present Law 

The Act provided certain targeted transitional rules. 
Explanation of Provision 

The bill makes certain corrections to the existing targeted transi- 
tional rules. 



' ^ For example, if a qualified person held stock of a corporation and subsequently contributed 
that stock to a partnership, the person's holding period would include the entire period the 
stock was held, directly or indirectly. 

The bill does not make any statutory change with respect to section 1223 since section 1223 
does not by its terms operate to extend attribution periods, as explained above. 



53 

F. Allocation of Purchase Price in Certain Sales of Assets (sec. 
106(h) of the bill, sec. 641 of the Reform Act, and sec. 1060 of 
the Code) 

Present Law 

Under the Act, in the case of an "applicable asset acquisition" 
both the buyer and the seller must allocate purchase price using 
the so-called "residual method" of allocation. Thus, both parties 
must use this method, as described in regulations under section 338 
of the Code.^^ An applicable asset acquisition is any transfer of 
assets constituting a business in which the transferee s basis is de- 
termined wholly by reference to the purchase price paid for the 
assets.^"* Both direct and indirect transfers of a business are cov- 
ered by this provision, including, for example, a sale of a business 
by an individual or a partnership, or a sale of a partnership inter- 
est in which the basis of the purchasing partner's proportionate 
share of partnership assets is adjusted to reflect the purchase price. 

The Treasury Department is authorized to require information 
reporting by the parties to an applicable asset acquisition. 

Explanation of Provisions 

The bill provides that section 1060 applies to a distribution or 
transfer of an interest in a partnership to which section 755 ap- 
plies, for purposes of determining the value of goodwill or going 
concern value (or similar items) under section 755.^^ 

The bill provides that any information reporting required by the 
Treasury Department pursuant to this provision constitutes an in- 
formation return for purposes of the penalty provisions of the 
Code. 

The bill makes certain other clerical and conforming changes. 

G. Related Party Sales (sec. 106(i) of the bill, sec. 642 of the 
Reform Act, and sec. 453 of the Code) 

Present Law 

Installment sale treatment is not available for gain on a sale of 
property to a related party; rather, the seller must include all pay- 
ments to be received in the year of the disposition. Contingent pay- 
ments must also be included in the seller's income in the year of 
disposition. Under the Act, in the rare and extraordinary case in 
which the fair market value of contingent payments may not be 
reasonably ascertained, basis shall be recovered ratably. The so- 
called "open transaction" cost-recovery method of reporting sanc- 
tioned in Burnet v. Logan, 283 U.S. 404 (1931) may not be used.^^ 



i^See. Temp. Treas. Reg. sec. 1.338Cb)-2T. The Act endorsed the use of the residual method 
generally and applied the same method regardless of whether a transfer took the form of a 
stock transfer or an asset transfer. The Act did not preclude the Treasury Department from 
making changes to the final regulations, not inconsistent with the statutory purpose. 

'* A transaction may constitute an applicable asset acquisition even though section 1031 (re- 
lating to like-kind exchanges) applies to a portion of the assets transferred. 

^^ The provisions of section 1060 of the Code are not intended to preclude the Internal Reve- 
nue Service from applying the residual method in other situations, including situations not in- 
volving an applicable asset acquisition, pursuant to its authority under other provisions of the 
Code. 

' 8 No inference was intended as to the viability of the cost recovery method under prior law. 



54 

The Act also provides that, in the case of such contingent pay- 
ments, the purchaser may not increase basis by any amount until 
the seller has included such amount in income. 

Related parties include a person and all entities more than 50 
percent owned, directly or indirectly, by that person. Related par- 
ties also generally include entities more than 50 percent owned, di- 
rectly or indirectly, by the same persons. 

Explanation of Provisions 

The bill clarifies that the requirement that the purchaser may 
not increase basis by any amount until the seller has included such 
amount in income applies not only to contingent payments as to 
which the fair market value may not be reasonably ascertained but 
also to any other amount in an installment sale of depreciable 
property between related parties. 

The bill also provides that related parties, for purposes of these 
installment sale provisions, include partnerships that are more 
than 50 percent owned, directly or indirectly, by the same persons. 

H. Amortizable Bond Premium (sec. 106(j) of the bill, sec. 643 of 
the Reform Act, and sec. 171 of the Code) 

Present Law 

The deduction for amortizable bond premium is treated as inter- 
est, except as otherwise provided in regulations. Thus, for example, 
bond premium is treated as interest for purposes of applying the 
investment interest limitations. 

The provision is effective for obligations acquired after October 
22, 1986. For taxpayers who have elections in effect as of October 
22, 1986, the statute provides that such elections will apply to obli- 
gations issued after that date only if the taxpayer so chooses (in 
such manner as may be prescribed by the Secretary). 

Explanation of Provision 

The bill provides that, for taxpayers who have elections in effect 
as of October 22, 1986, such elections will apply to obligations ac- 
quired after that date (rather than to obligations issued after that 
date) only if the taxpayer so chooses (in such manner as may be 
prescribed by the Secretary). 

I. Certain Entity Not Taxed as a Corporation (sec. 646 of the 
Reform Act and sec. 106(k) of the bill) 

Present Law 

The Act provided that a certain trust (Great Northern Iron Ore 
Trust) is not taxed as a corporation if specified conditions are satis- 
fied, including non-exercise of certain powers contained in its trust 
instrument. 



55 

Explanation of Provision 

The bill makes certain clarifications and corrections regarding 
the conditions that must be satisfied in order that the trust not be 
taxed as a corporation. 

J. Regulated Investment Companies (sees. 106(l)-106(o) of the bill, 
sees. 651-657 of the Reform Act, and sees. 851, 852 and 4982 of 
the Code) 

Present Law 

Under present law, in order to avoid paying an excise tax under 
section 4982, a regulated investment company ("RIC") is required 
to distribute during the calendar year specified percentages of its 
ordinary income and its capital gain net income for designated pe- 
riods. The amount of capital gain net income for this purpose is not 
reduced by the amount of any net operating loss of the RIC. 

A RIC is given sufficient earnings and profits under present law 
so that any distribution that otherwise is treated as dividend by 
the RIC may be treated as a dividend. No additional earnings and 
profits are created for redemption distributions that otherwise may 
qualify for a dividends paid deduction. 

Under present law, a RIC must derive at least 90 percent of its 
income from certain specified sources including income that is de- 
rived with respect to its business of investing in stocks, securities 
or currencies (the ''90 percent test"). In addition, a RIC must derive 
less than 30 percent of its gross income from the sale or other dis- 
position of stock or securities held for less than 3 months (the "30 
percent test"). 

Under present law, a corporation that is registered as a business 
development company under the Investment Company Act of 1940, 
is eligible to be a RIC. 

Explanation of Provisions 

Under the bill, for purposes of determining the amount that a 
RIC must distribute in order to avoid the excise tax under section 
4982, a RIC may reduce (but not below its net capital gain) its cap- 
ital gain net income (as computed for purposes of section 4981) by 
the amount of any "net ordinary loss" of the RIC. The net ordinary 
loss of the RIC is equal to the amount that would be the net oper- 
ating loss of the RIC for the calendar year, with certain modifica- 
tions. The net capital gain of the RIC for this purpose has the same 
meaning as under section 1221(11) determined by treating the one 
year period ending on October 31 of the calendar year (or such 
other one year period used by the RIC for purposes of section 4892) 
as the company's taxable year. 

Under the bill, in the case of a RIC that does not have a taxable 
year ending on October 31, and has not made an election to use its 
own taxable year for purposes of computing the excise tax under 
section 4982, the earnings and profits of the RIC are determined 
without regard to any net capital loss attributable to transactions 
after October 31 of such year, but only to the extent that the 
amount distributed during the calendar year does not exceed the 



56 

required distribution for such calendar year (as determined under 
section 4982). 

The bill clarifies that income derived by the RIC from a partner- 
ship or trust is not income that is considered to be derived with 
respect to the RIC's business of investing in stocks, securities or 
currencies. In addition, the bill clarifies that the 30 percent test is 
applied with respect to sales or other dispositions of the stocks or 
securities (as defined for purposes of the 90 percent test); options, 
futures, or forward contracts; or, except as provided in regulations, 
foreign currencies. 

The bill provides that a corporation that elects to be treated as a 
business development company under the Investment Company 
Act of 1940 is eligible to be a RIC. 

K. Real Estate Investment Trusts (sec. 106(o)-106(s) of the bill, 
sees. 661-669 of the Reform Act, and sees. 856-857 and 4981 of 
the Code) 

Present Law 

Under present law, at least 75 percent of the gross income of a 
real estate investment trust (a "REIT") must be derived from cer- 
tain specified sources including rents from real property and 
''qualified temporary investment income." Qualified temporary in- 
vestment income is income attributable to stock or debt instru- 
ments that is attributable to the temporary investment of new cap- 
ital (as defined in section 856(c)(6)(E)(ii)). In addition, present law 
provides that less than 30 percent of the gross income of a REIT 
must be derived from the sale or exchange of certain properties, in- 
cluding real property held for less than four years, with certain ex- 
ceptions (the "30 percent test"). 

Under present law, a REIT generally may not treat amounts as 
rents from real property if the determination of such amounts de- 
pends in whole or in part on the income or profits of any person 
from such property. An exception is provided where a REIT re- 
ceives or accrues amounts with respect to real or personal property 
from a tenant that derives substantially all of its income with re- 
spect to such property from the subleasing of substantially all of 
such property, and such tenant receives or accrues only amounts 
that would be treated as rents from real property if received by the 
REIT. A similar rule is provided for interest. 

Under present law, in order to avoid paying an excise tax under 
section 4981, a REIT is required to distribute during a calendar 
year specified percentages of its ordinary income and its capital 
gain net income for the calendar year. The amount of capital gain 
net income for this purpose is not reduced by the amount of any 
net operating loss of the REIT. 

Present law provides that income from a shared appreciation 
provision relating to a loan held by the REIT that is secured by a 
real property is treated as gain from the sale of the real property 
that secures the loan, effective for taxable years beginning after 
December 31, 1986. 



57 

Explanation of Provisions 

The bill clarifies that for purposes of the definition of qualified 
temporary investment income, the term "debt instrument" has the 
same meaning as used for purposes of section 1275(a)(1). The bill 
provides that in the year in which a REIT is completely liquidated, 
for purposes of the 30 percent test, the REIT does not take into ac- 
count any gain from the sale, exchange, or distribution of any prop- 
erty after the adoption of the plan of complete liquidation. The bill 
also provides that the provisions of the 1986 Act relating to the 
treatment of shared appreciation mortgages apply to taxable years 
beginning after December 31, 1986, but only with respect to obliga- 
tions acquired after October 22, 1986. 

The bill also clarifies that if a REIT receives or accrues amounts 
with respect to real or personal property from a tenant that de- 
rives substantially all of its income with respect to such property 
from the subleasing of substantially all of such property, and a por- 
tion of the amount that the tenant receives or accrues with respect 
to such property would be treated as rents from real property if re- 
ceived by the REIT, then the amounts received or accrued by the 
REIT from the tenant would not fail to be treated as rents from 
real property by reason of being based on the net income or profits 
of the tenant, to the extent that the amounts received or accrued 
by the REIT are attributable to amounts received by the tenant 
that would be treated as rents from real property if received by the 
REIT. A similar rule is provided for interest. In determining the 
portion of the rent (or interest) received from the tenant that may 
qualify as rent from real property (or interest) in these circum- 
stances, allocation rules similar to those applicable under section 
856(d)(4) (or section 856(f)(2)) are intended to apply. 

Under the bill, for purposes of determining the amount that a 
REIT must distribute in order to avoid the excise tax under section 
4981, a REIT may reduce its capital gain net income by the amount 
of any "net ordinary loss" of the REIT. The net ordinary loss of the 
REIT is an amount equal to the amount that would be the net op- 
erating loss of the REIT for the calendar year, with certain modifi- 
cations. 

L. Real Estate Mortgage Investment Conduits (sees. 106(t)-106(v) 
of the bill, sees. 671-675 of the Reform Act, and sees. 860A-860G 
and 856 of the Code) 

Present Law 

Under present law, if an entity ceases to be a real estate mort- 
gage investment conduit ("REMIC") at any time during a taxable 
year, the entity may not be treated as a REMIC for such taxable 
year or any succeeding taxable year. 

Under present law, a disposition of a qualified mortgage is treat- 
ed as a prohibited transaction for a REMIC, with certain excep- 
tions. No exception is provided for the repurchase of a defective 
mortgage in lieu of substitution. In addition, any disposition of a 
cash flow asset is treated as a prohibited transaction. Under 
present law, the treatment of contributions of property to the 
REMIC after the startup day is not certain. 



58 

Under present law, a qualified mortgage must be an obligation 
that is principally secured directly or indirectly by an interest in 
real property. It is unclear whether loans secured by stock in a co- 
operative housing corporation and debt instruments that are se- 
cured by other debt instruments, which other debt instruments are 
secured principally by interests in real property, may be treated as 
qualified mortgages. In general, a qualified mortgage must be 
transferred to a REMIC on or before the startup day, or purchased 
by the REMIC within three months of the startup day. 

Under present law, the terms of a regular interest in a REMIC 
must be fixed on the startup day. Present law provides that a resid- 
ual interest in a REMIC is any interest that is so designated and 
that is not a regular interest in a REMIC. Under present law, the 
startup day is any day selected by the REMIC that is on or before 
the first day on which regular interests in the REMIC are issued. 
Present law provides that a qualified reserve fund is any reason- 
ably required reserve to provide for full payment of expenses of the 
REMIC or amounts due on regular interests in the event of de- 
faults on qualified mortgages. 

Under present law, property that would be foreclosure property 
for a real estate investment trust is a permitted investment for a 
REMIC for a one year period beginning with the time that the 
REMIC acquires such property. No tax is imposed on the REMIC 
with respect to income from foreclosure property. 

Explanation of Provisions 

Under the bill, if an entity ceases to be a REMIC during a tax- 
able year by reason of a qualified liquidation, the entity may be 
treated as a REMIC for the taxable year in which the qualified liq- 
uidation occurs. 

The bill provides that the repurchase of a defective mortgage in 
lieu of substitution is not treated as a prohibited transaction. The 
bill also provides that the sale of cash flow investments required to 
prevent defaults on a regular interest where the threatened de- 
faults result from a default on one or more qualified mortgages is 
not treated as a prohibited transaction. In addition, if any property 
is contributed to the REMIC after the startup day, the bill imposes 
a tax on the REMIC for the taxable year in which the contribution 
is received equal to 100 percent of the amount (by value) of such 
contribution. Payments pursuant to a guarantee of qualified mort- 
gages are not intended to be treated as a contribution for this pur- 
pose. 

The bill clarifies the definition of a qualified mortgage by requir- 
ing that the qualified mortgage must be principally secured direct- 
ly by an interest in real property. Thus, under the bill, debt instru- 
ments that are secured by other debt instruments, which other 
debt instruments are secured principally by interests in real prop- 
erty, may not be treated as qualified mortgages. ^'^ Nevertheless, 
the bill provides that loans secured principally by stock in a coop- 
erative housing corporation may be treated as qualified mortgages. 



*' A regular interest in a REMIC, which is treated as a debt instrument for Federal income 
tax purposes, may be treated as a qualified mortgage, however. 



59 

The bill also provides that to be treated as a qualified mortgage, an 
obligation must be transferred to a REMIC on the startup day in 
exchange for regular or residual interests in the REMIC or pur- 
chased by the REMIC within three months of the startup day pur- 
suant to a fixed price contract in effect on the startup day.^^ 

The bill also provides that a regular interest in a REMIC must 
be issued on the startup day with fixed terms and must be desig- 
nated as a regular interest. Under the bill, a residual interest also 
must be issued on the startup day. Under the bill, the startup day 
is any day in which the REMIC issues all of its regular and residu- 
al interests. In addition, to the extent provided in regulations, all 
interests issued and all transfers to the REMIC during any period 
(not exceeding 10 days) permitted in such regulations may be treat- 
ed as occurring on the startup day. 

Under the bill, a qualified reserve fund is any reasonably re- 
quired reserve to provide for either full payment of expenses of the 
REMIC or amounts due on regular interests in the event of either 
defaults on qualified mortgages or lower than expected returns on 
cash flow investments. 

Under the bill, a REMIC is subject to tax at the highest rate ap- 
plicable to corporations on its "net income from foreclosure proper- 
ty." Net income from foreclosure property is the amount that 
would be the REMIC's net income from foreclosure property under 
section 857(b)(4)(B) if the REMIC were a real estate investment 
trust. Thus, if a REMIC acquires foreclosure property and receives 
amounts with respect to such property that would not be treated as 
certain types of qualifying income if received by a real estate in- 
vestment trust (sec. 857(b)(4)(B)), then the REMIC would be subject 
to tax on such amounts. In addition, such property generally would 
be treated as foreclosure property for a period of two years, al- 
though this period may be shortened or extended under certain cir- 
cumstances (sec. 856(e)). The amount of the REMIC's taxable 
income is reduced by any tax paid with respect to income from 
foreclosure property. 

The bill also grants authority to the Treasury Department to 
provide appropriate rules for the treatment of transfers of qualified 
replacement mortgages to a REMIC where the transferor holds any 
interest in the REMIC. It is intended that these regulations may 
provide rules for determining the basis of mortgages transferred to 
or received from a REMIC as part of a replacement of qualified 
mortgages, and also may provide rules for determining or adjusting 
the basis of qualified mortgages held by the REMIC before or after 
the replacement. In addition, the bill grants authority to the Treas- 
ury Department to provide that a mortgage will be treated as a 
qualified replacement mortgage only if it is part of a bona fide re- 
placement and is not part of a swap of mortgages. 

The bill clarifies that certain provisions relating to REMICs are 
effective as of January 1, 1987. Thus, for example, interests in a 
REMIC are eligible to be treated as qualifying assets for a thrift 



'® For this purpose, mortgages may be considered to be purchased pursuant to a fixed price 
contract despite the fact that the purchase price may be adjusted where the mortgages are not 
delivered by the seller on the startup day, provided that the adjustment is in the nature of dam- 
ages for failure to deliver the mortgages rather than as a result of fluctuations in market price 
between the startup day and the date of delivery. 



60 

institution, regardless of the institution's taxable year. In addition, 
the bill makes certain clerical and technical amendments to the 
statute. 

In general, the provisions of the bill are effective as of January 1, 
1987. The provisions relating to the definition of the startup day, 
the definitions of regular and residual interests, the requirement 
that qualified mortgages be transferred to the REMIC in exchange 
for regular or residual interests on the startup day or purchased 
pursuant to a fixed price contract, and the 100-percent tax on con- 
tributions of property to REMICs after the startup day do not 
apply to any REMIC whose startup day (as defined under present 
law) is before July 1, 1987. 



VII. Minimum Tax Provisions (Sec. 107 of the bill, sec. 501 of the 
Reform Act, and sees. 55-59 of the Code) 

Present Law 

Under present law, as amended by the Act, taxpayers are subject 
to an alternative minimum tax which is payable, in addition to all 
other tax liabilities, to the extent it exceeds the taxpayer's regular 
tax. The tax is imposed at a flat rate of 21 percent (20 percent in 
the case of a corporation) on alternative minimum taxable income 
in excess of an exemption amount. Alternative minimum taxable 
income generally is the taxpayer's taxable income, as increased or 
decreased by certain adjustments and preferences. The foreign tax 
credit and, to a limited extent in the case of corporations, the in- 
vestment tax credit are allowed against the minimum tax. 

Adjustments and preferences are provided for accelerated depre- 
ciation, mining exploration and development costs, certain long- 
term contracts, pollution control facilities, installment sales, circu- 
lation and research and experimental expenditures, individual 
itemized deductions. Merchant Marine Capital Construction Funds, 
special insurance deductions, percentage depletion, excess intangi- 
ble drilling costs, incentive stock options, bad debt reserves, tax- 
exempt interest on certain bonds, appreciated property charitable 
deductions, farm losses, and passive losses. In addition, for 1987 
through 1989, one-half of the excess of pre-tax book income of a 
corporation over other alternative minimum taxable income is a 
preference. For taxable years beginning after 1989, three-fourths of 
the excess of adjusted current earnings over other alternative mini- 
mum taxable income is a preference. 

The provisions are effective for taxable years beginning after De- 
cember 31, 1986. 

Explanation of Provisions 

Computation of tax. — The bill provides that a taxpayer's regular 
tax will be reduced by the possessions tax credit under section 27(b) 
since income eligible for the credit is not included in the minimum 
tax base. The bill also clarifies that where a corporation's tax base 
is measured by something other than taxable income, such as unre- 
lated business taxable income, real estate investment trust taxable 
income, or life insurance company taxable income, alternative min- 
imum taxable income is determined using that tax base. 

Adjustments. — The bill clarifies that the percentage of contract 
completed used for purposes of determining the minimum tax ad- 
justment for long-term contracts is the same percentage as used for 
regular tax purposes under section 460. The bill also clarifies that 
the deduction for regular tax purposes for personal exemptions is 
not allowed under the minimum tax, since a minimum tax exemp- 

(61) 



62 

tion amount is provided. Further, the bill provides that only inter- 
est which is qualified residence interest for purposes of the regular 
tax may qualify as deductible housing interest for purposes of the 
minimum tax, and clarifies that minimum tax investment interest 
does not include minimum tax housing interest. 

Book income. — The bill provides that an income statement that is 
filed with a Federal, state, or local government must be prepared 
for a substantial nontax purpose in order to be an applicable finan- 
cial statement. Thus, an income tax return, franchise tax return or 
other similar return prepared for the purpose of determining any 
tax liability that is filed with Federal, State, or local authorities 
does not constitute an applicable financial statement. In addition, 
an income statement used by a government for statistical purposes 
only is not prepared for a substantial nontax purpose. The bill also 
provides that if a taxpayer has two or more financial statements 
with the same priority, the applicable financial statement shall be 
the one specified in regulations promulgated by the Secretary of 
the Treasury. 

The gross amount of dividends (i.e. gross of any withholding 
taxes) received from a section 936 corporation, like dividends re- 
ceived from other nonconsolidated corporations, are included in the 
recipient's adjusted net book income. To the extent that the alter- 
native minimum taxable income of the recipient is increased by 
reason of the inclusion of such dividends in adjusted net book 
income, the bill clarifies that a pro rata portion of withholding or 
income taxes is treated, for minimum tax purposes, as creditable 
foreign taxes paid by the recipient. The maximum amount of with- 
holding or income taxes that may be treated as creditable foreign 
taxes is 50 percent of the taxes. However, this amount is reduced 
on a proportionate basis if a lesser amount of the dividends from 
the 936 corporation is taken into account in computing alternative 
minimum taxable income. 

The bill also clarifies that if a taxpayer does not choose to take 
the benefit of section 901 with respect to income, war profits, or 
excess profits taxes imposed by a foreign country or possession of 
the United States, or is prohibited from taking the benefit of sec- 
tion 901 (i.e. taxes described in section 901(j)), adjusted net book 
income is reduced by only those taxes. That is, taxes which are not 
deductible for regular tax purposes (for example, withholding or 
income taxes imposed by a U.S. possession on dividends received 
from a section 936 corporation) are not deductible for this purpose. 
Similarly, the related income is to be reflected gross of any of these 
nondeductible taxes. 

Adjusted current earnings. — The bill clarifies that the rule pro- 
viding that income on an annuity contract is included in adjusted 
current earnings does not apply to a qualified annuity contract 
held under a plan described in section 403(a). 

Preferences. — The bill clarifies that the preference for bond inter- 
est only applies to tax-exempt bonds and the exception for refund- 
ing bonds includes both current and advanced refundings. The bill 
also clarifies that the charitable contribution preference applies to 
trusts and estates as well as all other taxpayers. Finally, the bill 
provides that the incentive stock option preference applies notwith- 
standing that the stock is disposed of in a disqualifying disposition. 



63 

Investment tax credits. — The bill clarifies that the total amount 
of the general business credit allowable to a C corporation for a 
taxable year in which the regular tax exceeds the tentative mini- 
mum tax is determined as if any portion of the general business 
credit not attributable to the regular investment tax credit first 
offset the regular tax, and the regular investment credits (to the 
extent otherwise available) then reduced the net tax to 75 percent 
of the tentative minimum tax. 

For example, assume a corporation had $100 million of regular 
tax, $80 million of tentative minimum tax, $30 million of regular 
investment tax credits (disregarding the cutback under section 49 
for purposes of this example), and $20 million of other general busi- 
ness credits. $40 million of the general business credit would be al- 
lowed for the taxable year — $20 million by reason of the general 
rule of section 38(c)(1) allowing the general business credit to offset 
the excess of regular tax over tentative minimum tax and $20 mil- 
lion by reason of the special rule of section 38(c)(3) allowing unused 
regular investment credits to offset 25 percent of the tentative min- 
imum tax. The above result would occur without regard to the tax- 
able years in which the various credits arose. 

The bill also clarifies that the regular investment tax credit 
cannot be used in a taxable year to the extent that it, in conjunc- 
tion with the NOL deduction and the foreign tax credit, would 
reduce the amount of tax payable by the taxpayer to less than 10 
percent of the tentative minimum tax (determined without regard 
to the NOL deduction and foreign tax credits). 

Clerical amendments. — The bill makes numerous clerical amend- 
ments and corrects several cross references to these provisions. 

Transitional provisions. — The bill provides that, for property that 
is depreciated under the new ACRS system during a taxable year 
of the taxpayer that begins before 1987, the new minimum tax de- 
preciation (or pollution control facility amortization) rules apply to 
measure the preference, but the preference applies only to property 
to which the prior law rules of paragraphs (4) and (12) of section 
57(a) applied. The bill also provides that in the case of a fiscal year 
trust or estate beginning in 1986 and ending in 1987, the prior law 
apportionment rules will apply notwithstanding that a benefi- 
ciary's taxable year begins in 1987. The bill also contains certain 
transition rules that were inadvertently amended or deleted in en- 
rolling the Act. 



VIII. Accounting Provisions (Sec. 108 of the Bill) 

1. Limitation on the use of the cash method of accounting (sec. 
108(a) of the bill, sec. 801 of the Reform Act, and sees. 448, 461, 
and 464 of the Code) 

a. Definition of qualified personal service corporations 
Present Law 

Qualified personal service corporations are excepted from the 
general rule denying the use of the cash method of accounting to a 
C corporation or a partnership with a C corporation as a partner. A 
qualified personal service corporation is a corporation that meets 
both a function test and an ownership test. The function test is met 
if substantially all the activities of the corporation are the perform- 
ance of services in the field or fields of health, law, engineering, 
architecture, accounting, actuarial science, performing arts, and 
consulting. 

The ownership test is met if substantially all (i.e., 95 percent) of 
the value of the outstanding stock in the corporation is owned, di- 
rectly or indirectly, by employees performing services for the corpo- 
ration in connection with the qualified services performed by the 
corporation, retired individuals who performed such services for 
the corporation or its predecessor(s), the estate of such an individ- 
ual, or any other person who acquired stock by reason of the death 
of such an employee (for the two-year period beginning with the 
death of such employee). 

A special rule is provided allowing the common parent of an af- 
filiated group (within the meaning of section 1504(a)) to elect to 
treat all members of such affiliated group as one taxpayer for the 
purpose of determining if the ownership test is met, provided that 
substantially all of the activities of the members of such affiliated 
group involve the performance of services in the same field satisfy- 
ing the function test. 

Explanation of Provision 

The bill provides that, for the purpose of determining if a corpo- 
ration meets the ownership test, indirect ownership of stock is to 
be taken into account only where stock is owned indirectly through 
one or more partnerships, S corporations, or qualified personal 
service corporations. Thus, other forms of indirect stock ownership 
(e.g., as a result of attribution between family members or a hold- 
ing company) are not considered in determining if the ownership 
test is satisfied. Stock that is owned by a partnership, S corpora- 
tion, or qualified personal service corporation is considered to be 
owned by its owners in the same proportion as their ownership of 

(64) 



65 

the partnership, S corporation or qualified personal service corpo- 
ration. 

The bill also provides that a common parent of an afiiliated 
group may elect to treat all members of such group as one taxpay- 
er for the purpose of determining if the ownership test is met 
where substantially all of the activities of such affiliated group in- 
volve the performance of services in the same field satisfying the 
function test. Thus, if substantially all of the activities of the affili- 
ated group, taken as a whole, are the performance of services in a 
field satisfying the function test, an election is available to apply 
the ownership test to the group as a whole. The function test, how- 
ever, must still be applied to each separate corporation. 

b. Requirement that tax shelters in oil and gas must pay 

cash before year end 

Present Law 

Under section 461(i), in the case of tax shelters, no deduction is 
allowed with respect to an item until there has been economic per- 
formance with respect to that item. Under a special rule applicable 
to tax shelters in oil and gas, economic performance with respect to 
drilling of an oil or gas well is deemed to occur at the time of spud- 
ding. 

Explanation of Provision 

When the special spudding rule for economic performance was 
adopted by Congress in the Defict Reduction Act of 1984, economic 
performance was deemed to occur at the time of spudding of an oil 
or gas well where the taxpayer had paid for the drilling costs prior 
to the close of the taxpayer's year. The Reform Act inadvertently 
removed the requirement that the taxpayer must have paid for the 
drilling costs by the close of the taxpayer's year in order for the 
special spudding rule to apply. The bill provides that tax shelters 
in oil and gas must have paid for the drilling activity before the 
end of its taxable year in order for spudding to be considered as 
economic performance. 

c. Limitations on farming deductions 

Present Law 

Under Code section 464(a), farming syndicates are allowed a de- 
duction for amounts paid for feed, seed, fertilizer, or other similar 
farm supplies no earlier than the taxable year in which such feed, 
seed, fertilizer, or other supplies actually are used or consumed. 

Under Code section 464(b), farming syndicates are required to 
capitalize the cost of poultry purchased for use in a trade or busi- 
ness and to deduct such cost ratably over the lesser of 12 months or 
the useful life of such poultry in the trade or business. In addition, 
a farming syndicate may deduct only the cost of poultry purchased 
for sale in the taxable year in which the poultry is disposed of. 

The Reform Act applies Code section 464(a) and 464(b) to certain 
persons prepaying 50 percent or more of certain farming expenses, 
with respect to the portion of such expenses exceeding 50 percent. 



66 

The Act denies the use of the cash method of accounting to any 
tax shelter. The definition of tax shelter for this purpose includes 
all farming syndicates. 

Explanation of Provision 

The bill provides that sections 464(a) and 464(b) shall not apply 
to farming syndicates in taxable years beginning after December 
31, 1986, because these rules are duplicated by the rules of the 
Reform Act that require tax shelters to use an accrual method of 
accounting. 

2. Capitalization rules for inventory, construction, and develop- 
ment costs (sec. 108(b) of the bill, sec. 803 of the Reform Act, 
and section 263A of the Code) 

Present Law 

In general, uniform cost capitalization rules apply to the manu- 
facture or construction of all tangible property and to the purchas- 
ing and holding property for resale. Exceptions to these rules are 
provided for property produced by the taxpayer for personal use, 
research and experimental costs allowable as a deduction under 
section 174, certain development and other costs of oil and gas 
wells and mineral property deductible under section 263(c), 616(a), 
or 617(a), property produced pursuant to a long-term contract, and 
the production of timber and certain ornamental trees. 

Interest costs are subject to special rules. Capitalization of inter- 
est is required only if the taxpayer is engaged in the manufacture 
or construction of property (i.e., resellers are exempt), and only if 
the property produced is real property or personal property that is 
long-lived or has an extended production period. Interest costs are 
allocable to the production or construction of property if they are 
directly attributable to production expenditures incurred in produc- 
ing the property, or could have been avoided if the production ex- 
penditures had not been incurred. Interest incurred or continued in 
connection with property used to produce property is also subject 
to capitalization. 

Special rules also apply to the production of farm products. In 
general, the uniform capitalization rules apply to such production 
only if the product has a preproductive period of more than two 
years. The special rule do not apply to taxpayers required to use an 
accrual method of accounting under section 447 or 448. Except for 
taxpayers using the annual accrual method of accounting, taxpay- 
ers required to use an accrual method of accounting must capital- 
ize preproductive expenses. 

Certain farmers otherwise required to capitalize preproductive 
period costs may elect to deduct them currently, provided the alter- 
native cost recovery system is used on all farm assets and the ex- 
pensed costs are recaptured upon disposition of the product. The 
election is not available to taxpayers required to use the accrual 
method of accounting or engaged in the production of pistachios. In 
addition, costs incurred in replanting edible crops following loss or 
damage due to freezing temperatures, disease, drought, pests, or 
casualty may be deducted currently. This exception may apply to 



67 

costs incurred by persons other than the taxpayer who incurred 
the loss or damage, provided (1) the taxpayer who incurred the loss 
or damage retains an equity interest of more than 50 percent in 
the property on which the loss or damage occurred and (2) the 
person claiming the deduction materially participates in the plant- 
ing or maintenance of the property during the four-taxable year 
period beginning with the year of the loss or damage. 

Explanation of Provision 

The bill adds to the list of costs specifically exempted from the 
uniform capitalization rules (1) costs incurred in connection with 
oil and gas wells or mineral property that are subject to amortiza- 
tion over sixty months pursuant to section 291(b)(2), and (2) costs 
(other than circulation expenditures) subject to ten-year amortiza- 
tion under section 59(e). The bill also clarifies that, in determining 
the amount of interest that must be capitalized in connection with 
an asset used to produce property, the methods applied under the 
general interest allocation rules are applied to the full cost of the 
asset. ^ Accordingly, any interest specifically traceable to such an 
asset must first be allocated to the produced property; interest on 
other debt of the taxpayer is then allocated to the extent required 
under the avoided cost method. ^ 

Finally, the bill clarifies that a cost is subject to capitalization 
under this provision only to the extent it is otherwise taken into 
account in computing taxable income for any taxable year. Thus, 
for example, the portion of a taxpayer's interest expense that is al- 
locable to personal loans, and hence is disallowed under section 
163(h), may not be included in a capital or inventory account and 
recovered through depreciation or amortization deductions, as a 
cost of sales, or in any other manner. 

The special rule for costs incurred by persons other than the tax- 
payer in connection with replanting a crop of the taxpayer follow- 
ing loss or damage due to freezing temperatures, etc., is modified. 
Under the bill, such costs may be deducted without regard to 
whether they were incurred (or the persons' material participation 
occurs) within the four-taxable year period following the loss or 
damage. 

Many taxpayers using the annual accrual method of accounting, 
other than taxpayer's engaged in the trade or business of growing 
sugar cane, were required under section 278 of prior law to capital- 
ize preproductive expenses (e.g., citrus growers). The Reform Bill 
repealed section 278. The bill restricts the taxpayers that use the 
annual accrual method of accounting that may expense preproduc- 
tive expenses to taxpayers engaged in the trade or business of 
farming sugar cane. 



1 If an asset is not used exclusively in the production of a single property, the total interest 
cost associated with the asset is allocated among the various properties produced. 

2 To avoid double counting, any interest allocated to property under this rule is not again allo- 
cated to the property under the general interest allocation rule. For example, interest allocated 
under the general rule to depreciation on an asset used to produce property, which would be a 
production expenditure that would "attract" interest under the avoided cost method, might oth- 
erwise duplicate interest allocated under this special rule for production-related assets. 



68 

3. Long-term contracts (sec. 108(c) of the bill, sec. 804 of the 
Reform Act, and sec. 460 of the Code) 

Present Law 

Taxpayers engaged in the production of property under a long- 
term contract must compute income from the contract under either 
the percentage of completion method or the percentage of comple- 
tion-capitalized cost method. Under the percentage of completion 
method, the taxpayer must include in gross income for the taxable 
year an amount equal to the product of (1) the gross contract price 
and (2) the percentage of the contract completed during the taxable 
year. The percentage of a contract completed during the taxable 
year is determined by comparing costs incurred with respect to the 
contract during the year with the estimated total contract costs. 

In the taxable year in which a contract reported under the per- 
centage of completion method is completed, a determination is 
made whether the taxes paid with respect to the contract in each 
year of the contract were more or less than the amount that would 
have been paid if gross income had been computed by using the 
actual gross contract price and the actual total contract costs, 
rather than the anticipated contract price and costs. Interest must 
be paid by the taxpayer if, applying this "lookback" method, there 
is an underpayment by the taxpayer with respect to a taxable year. 
Similarly, interest must be paid to the taxpayer by the Internal 
Revenue Service if there is an overpayment. 

Under the percentage of completion-capitalized cost method, the 
taxpayer must take into account 40 percent of the items with re- 
spect to the contract under the percentage of completion method. 
The remaining 60 percent of the items under the contract must be 
taken into account under the taxpayer's normal method of account- 
ing (e.g., completed contract method, accrual shipment method). 

Costs that directly benefit, or are incurred by reason of, a tax- 
payer's long-term contract activities must be allocated to its long- 
term contracts in the manner provided in the Treasury regulations 
under section 451 for extended period long-term contracts. This 
method of allocation is required irrespective of whether the con- 
tract is reported under the percentage of completion-capitalized 
cost method or the percentage of completion method. While costs 
may be deducted in the year incurred if they relate to a contract 
(or portion of a contract) reported under the percentage of comple- 
tion method, whether costs are allocable to such a contract is none- 
theless relevant because it affects the determination of the percent- 
age of the contract completed during the year. 

Explanation of Provision 

The bill authorizes the Secretary of the Treasury to prescribe a 
simplified procedure for the allocation of costs to a contract for 
purposes of applying the percentage of completion method. Thus, 
for example, the Secretary may permit the determination of the 
percentage of a contract completed during the taxable year to be 
based on fewer costs than are taken into account for purposes of 
applying the completed contract method or other long-term con- 
tract method of accounting. This simplified method may not be 



69 

used by taxpayers using the percentage of completion-capitalized 
method for accounting for long-term contracts. 

4. Taxable years of certain entities (sec. 108(e) of the bill, sec. 806 
of the Reform Act, and sees. 706, 1378, 441, and 267 of the 
Code) 

a. Majority interest taxable years 
Present Law 

A partnership may not have a taxable year other than the tax- 
able year of the partners owning a majority interest in partnership 
profits and capital. If partners owning a majority of partnership 
profits and capital do not have the same taxable year, the partner- 
ship must adopt the same taxable year as its principal partners. If 
the principal partners of the partnership do not have the same tax- 
able year and no majority of its partners have the same taxable 
year, the partnership must adopt the calendar year or such other 
period as the Secretary of the Treasury may prescribe by regula- 
tions. 

The majority interest rule does not apply unless the period that 
constitutes the taxable year of partners owning a majority interest 
in partnership profits and capital has been the same for the three- 
taxable-year period of such partners ending on or before the begin- 
ning of such taxable year of the partnership. If the partnership has 
not been in existence for all of such three-taxable-year period, the 
period that constitutes the taxable year of the partners owning a 
majority interest in profits and capital must have been the same 
for the taxable years of such partners ending with or within the 
period of the partnership's existence. 

Explanation of Provision 

The bill provides that a partnership may not have a taxable year 
other than its majority interest taxable year. If the partnership 
does not have a majority interest taxable year, it may not have a 
taxable year other than the taxable year of all of its principal part- 
ners. If the partnership does not have a majority interest taxable 
year and all of its principal partners do not have the same taxable 
year (or the partnership has no principal partners), the partnership 
may not have a taxable year other than the calendar year, unless 
the Secretary of the Treasury, by regulations, prescribes another 
period. 

The majority interest taxable year is the taxable year (if any) 
that, on the testing day, constituted the taxable year of one or 
more partners having (on the testing day) an aggregate interest in 
partnership profits and capital of more than 50 percent. Generally, 
the testing day is the first day of the partnership taxable year. The 
Secretary of the Treasury may provide that an alternate, repre- 
sentative period be used as the testing day, rather than the first 
day of the taxable year, if such period is more representative of the 
ownership of the partnership. A partnership that is required to 
change its taxable year to its majority interest taxable year is not 
required to change to another taxable year for either of the two 
taxable years following the year of change. 



70 

b. Sequence of required changes in taxable years 

Present Law 

The requirement of the Reform Act that partnerships conform 
their taxable years to the taxable years of their owners does not 
take into consideration changes in taxable years of such owners 
that also may be required by the Act. Thus, such partnerships may 
be required to change their taxable years several times as the tax- 
able years of their owners change. 

Explanation of Provision 

The bill provides that, except as otherwise provided in the regu- 
lations issued by the Treasury Regulations, the changes in taxable 
years of other persons required to change taxable years are to be 
taken into account in determining the required taxable year of a 
partnership. 

c. Personal service corporations 

Present Law 

A personal service corporation is required by the Reform Act to 
adopt a calendar year, unless it establishes to the satisfaction of 
the Secretary of the Treasury a business purpose for a different 
taxable year. A personal service corporation is a corporation the 
principal activity of which is the performance of personal services 
if services are substantially performed by employee-owners. 

Explanation of Provision 

The bill provides that a corporation is not considered to be a per- 
sonal service corporation for this purpose unless more than 10 per- 
cent of the stock (by value) in such corporation is held by employ- 
ee-owners. 

The bill further provides that, if a corporation is a member of an 
affiliated group filing a consolidated return, all members of such 
group shall be taken into account in determining whether such cor- 
poration is a personal service corporation. 

d. Common trust funds 

Present Law 

The Reform Act did not address the taxable year to be used by a 
common trust fund taxed under section 584. 

Explanation of Provision 

Consistent with the rules requiring use of a calendar year for 
other pass-through entities (e.g., partnerships, S corporations, 
trusts), the bill requires the taxable year of a common trust fund 
be the calendar year. If a common trust fund is required to change 
taxable years as a result of this provision, and as a result of such 
change a participant in such common trust fund is required to in- 
clude items from more than one taxable year of the common trust 
fund in any of the participant's taxable years, the items from the 



71 

short taxable year of the common trust fund may be included in 
income by the participant ratably over a four-taxable-year period, 
unless the participant elects to include all such income currently. 

e. Effective date 

Present Law 

The Reform Act provided that, if any partner or shareholder of 
an S corporation is required to include the items from more than 
one taxable year of the partnership or S corporation in any one 
taxable year, income in excess of expenses for the short taxable 
year of the partnership or S corporation is to be taken into account 
ratably in each of the first four taxable years (including such short 
taxable year) beginning after December 31, 1986, unless the part- 
ner or shareholder of the S corporation elects to include all such 
income in the short taxable year. 

The Internal Revenue Service has issued a revenue procedure 
which sets forth rules under which the Service will permit electing 
S corporations to adopt taxable years other than a calendar year. 
Rev. Proc. 83-25, 1983-1 C.B. 689. Under the so-called "25-percent 
test" of that revenue procedure, an electing S corporation generally 
may adopt, retain, or change to a taxable year if, among other 
tests, 25 percent or more of the gross income of the taxpayer is re- 
alized in the last two months of that year. 

Explanation of Provision 

The bill clarifies that the four year spread provided by the 
Reform Act for partners and shareholders in S corporations is only 
applicable to changes in taxable years that are required by the 
Reform Act for the first taxable year beginning after December 31, 
1986. In addition, the bill clarifies that the four year spread is 
made at that partner or shareholder level, rather than at the level 
of the partnership or S corporation. 

The bill provides that the Internal Revenue Service is not re- 
quired to permit taxpayers to have an automatic change of a tax- 
able year. Thus, taxpayers meeting the "25-percent test" of Rev. 
Proc. 83-25 are not automatically permitted to adopt or change to a 
year allowed under that revenue procedure. 

5. Treatment of installment obligations (sec. 108(f) of the bill, sec. 
812 of the Reform Act, and sees. 453 and 453C of the Code) 

Present Law 

In applying the proportionate disallowance rule under present 
law, the installment percentage of a taxpayer's average quarterly 
indebtedness generally is treated as a payment on the taxpayer's 
applicable installment obligations. The taxpayer's year-end indebt- 
edness may be used instead of average quarterly indebtedness if 
the taxpayer has no applicable installment obligations arising from 
dealer sales outstanding at any time during the taxable year. In 
addition, in applying the proportionate disallowance rule, all assets 
and indebtedness of certain related taxpayers are aggregated. 



72 

Under present law, applicable installment obligations include in- 
stallment obligations arising from certain specified types of sales, 
which installment obligations are held by the seller or a member of 
the same affiliated group (within the meaning of section 1504(a) 
without regard to section 1504(b)) as the seller. Obligations arising 
from sales of personal property pursuant to a revolving credit plan 
or obligations arising from the sale of publicly traded property may 
be treated as applicable installment obligations. Under present 
law, personal use property and indebtedness secured primarily by 
such property are not taken into account for purposes of applying 
the proportionate disallowance rule of section 453C to applicable 
installment obligations arising from dealer sales. 

Under present law, taxpayers who are required to change their 
method of accounting for sales pursuant to a revolving credit plan 
because of section 812 of the Reform Act must take into income 
any adjustment arising under section 481 over a period of four 
years, with specified percentages for each of the four years. 

Explanation of Provisions 

The bill provides that taxpayers who have no applicable install- 
ment obligations outstanding at year-end other than applicable in- 
stallment obligations arising from non-dealer sales, must use their 
year-end indebtedness, rather than their average quarterly indebt- 
edness for purposes of applying the proportionate disallowance 
rule. The bill provides that personal use property and indebtedness 
secured primarily by such property are not taken into account for 
purposes of applying the proportionate disallowance rule of section 
453C to applicable installment obligations arising from non-dealer 
sales. The bill also grants authority to the Treasury Department to 
issue regulations modifying the rules requiring aggregation of the 
assets and indebtedness of certain related taxpayers. 

The bill clarifies that the term "applicable installment obliga- 
tion" includes installment obligations arising from certain specified 
types of sales, which installment obligations are held by the seller 
or any person if the basis of such obligation in the hands of such 
person is determined (in whole or in part) by reference to the basis 
of such obligation in the hands of another person and such obliga- 
tion was an applicable installment obligation in the hands of such 
other person. Thus, for example, if an applicable installment obli- 
gation is transferred to a partnership or a trust in a nonrecognition 
transaction and the partnership or trust has a carryover basis in 
the installment obligation, then the obligation is treated as an ap- 
plicable installment obligation in the hands of the partnership or 
trust. 

The bill also clarifies that installment obligations arising from 
the sale of personal property pursuant to a revolving credit plan or 
from the sale of publicly traded property are not treated as applica- 
ble installment obligations. Thus, such installment obligations are 
not subject to the proportionate disallowance rule. In addition, the 
bill clarifies that the provision denying the use of the installment 
method for sales of publicly traded property applies with respect to 
sales of such property after December 31, 1986. 



73 

In addition, the bill clarifies how the proportionate disallowance 
rule is applied with respect to applicable installment obligations 
arising after February 28, 1986, but in a taxable year prior to the 
first taxable year ending after December 31, 1986. The bill specifies 
that any such applicable installment obligations are treated as 
arising on the first day of the first taxable year of the taxpayer 
ending after December 31, 1986. 

The bill provides that if a taxpayer's last taxable year beginning 
before January 1, 1987, was the taxpayer's first taxable year in 
which sales were made under a revolving credit plan, then all ad- 
justments under section 481 are taken into account in the taxpay- 
er's first taxable year beginning after December 31, 1986. The bill 
also provides that if a taxpayer sells any receivables that arose 
pursuant to a revolving credit plan and that were taken into ac- 
count in computing the adjustment under section 481 relating to 
the change from the installment method to the accrual method, 
then the taxpayer may not recognize any loss on the sale of such 
receivables. If a loss is realized on any such sale, however, then the 
taxpayer may reduce the aggregate amount of the adjustment 
under section 481 for the fourth taxable year beginning after De- 
cember 31, 1986, by the amount of such loss; to the extent that the 
loss exceeds the aggregate adjustment for such fourth taxable year, 
then the adjustment for the third taxable year is reduced, and so 
on. 

Further, the bill corrects certain clerical and technical errors. 

6. Income attributable to utility services (sec. 108(i) of the bill, 
sec. 821 of the Reform Act, and sec. 451 of the Code) 

Present Law 

Accrual basis taxpayers are required to recognize income attrib- 
utable to the furnishing or sale of utility services to customers not 
later than the taxable year in which such services are provided to 
the customer. For taxable years beginning after December 31, 1986, 
the year in which utility services are provided may not be deter- 
mined by reference to the time the customer's meter is read or to 
the time that the customer is billed (or may be billed) for such 
services. 

For any taxable year beginning before August 16, 1986, a method 
of accounting that took into account income from the furnishing or 
sale of utility services on the basis of the period in which the cus- 
tomer's meters were read is deemed to be proper for Federal 
income tax purposes. 

Explanation of Provision 

The bill provides that, for taxable years beginning on or after 
August 16, 1986, and before January 1, 1987, a method of account- 
ing that took into account income from the furnishing or sale of 
utility services on the basis of the period in which the customer's 
meters v'^ere read is deemed to be proper for Federal income tax 
purposes, provided such income was treated in the same manner 
for the preceding taxable year. 



IX. Financial Institutions (Sec. 109 of the Bill) 

1. Limitations on bad debt reserves (sec. 109(a) of the bill, sec. 901 
of the Reform Act, and sec. 46(c)(4) of the Code) 

Present Law 

Section 901 of the Act reduced the portion of taxable income that 
thrift institutions (mutual savings banks, domestic building and 
loan associations, and cooperative banks) may deduct as an addi- 
tion to reserves for bad debts from a maximum of 40 percent to 
eight percent. In addition, an institution otherwise meeting the def- 
inition of a thrift institution was required to hold at least 60 per- 
cent of its assets in qualifying assets in order to meet the definition 
of a thrift institution. 

Prior and present law limits the amount of investment eligible 
for the investment tax credit in the case of a thrift institution to 50 
percent of the amount otherwise allowable. Where a thrift institu- 
tion is the lessee of property that is eligible for the investment tax 
credit, the lessor is treated as a thrift institution with respect to 
such property, unless the thrift institution has elected to compute 
its deduction for bad debts using the experience method. Such an 
election is binding on the thrift institution for all subsequent years. 

Explanation of Provision 

The bill provides that an election by a lessee thrift institution to 
use the experience method of computing its deduction for bad debts 
shall terminate effective with respect to the first taxable year of 
the electing organization beginning after 1986 and during which 
such organization (or any successor organization) was not the lessee 
under any lease of regular investment tax credit property. Regular 
investment tax credit property is any section 38 property if the reg- 
ular percentage applied to such property and the amount of quali- 
fied investment with respect to such property would have been re- 
duced but for the election by the organization. 

The effect of the provision is to allow a thrift institution that had 
committed to the use of the experience method of accounting for 
bad debts in order to avoid certain reductions in investment tax 
credit to use the percentage of income method in taxable years be- 
ginning after 1986, provided the thrift institution is not a lessee of 
property that was eligible for investment tax credit without reduc- 
tion as a result of the prior election. 

(74) 



75 

2. Interest on debt used to purchase or carry tax-exempt obliga- 
tions (sec. 109 of the bill, sec. 902 of the Act, and sees. 265 and 
291 of the Code) 

Present Law 

The Act denies banks, thrift institutions, and other financial in- 
stitutions a deduction for that portion of the taxpayer's otherwise 
allowable interest expense that is allocable to tax-exempt obliga- 
tions acquired by the taxpayer after August 7, 1986 (sec. 265(b)). ^ 
The portion of interest disallowed is equivalent to the ratio of (1) 
the average adjusted basis during the taxable year of tax-exempt 
obligations held by the financial institution and acquired after 
August 7, 1986, to (2) the average adjusted basis of all assets held 
by the financial institution. A 20-percent disallowance continues to 
apply (as under pre-1986 law) with respect to tax-exempt obliga- 
tions acquired between January 1, 1983, and August 7, 1986. 

An exception to the proportional disallowance rule is provided 
for qualified tax-exempt obligations acquired by a financial institu- 
tion. Qualified tax-exempt obligations include any tax-exempt obli- 
gation which (1) is not a private activity bond, as defined under 
Title XIII of the Act,^ and (2) is issued by an issuer which reason- 
ably anticipates to issue not more than $10 million of tax-exempt 
obligations (other than private activity bonds, as defined above) 
during the calendar year. Qualified tax-exempt obligations must be 
designated as such by the issuer; not more than $10 million of obli- 
gations may be so designated for any calendar year. 

For purposes of applying the limitations with respect to qualified 
tax-exempt obligations, an issuer and all subordinate entities are 
treated as one issuer. 

Qualified tax-exempt obligations are treated as if acquired by the 
financial institution on August 7, 1986. Interest allocable to such 
obligations thus remains subject to the 20 percent disallowance 
rule contained in pre-1986 law. 

Explanation of Provisions 

The bill makes several amendments to the exception for qualified 
tax-exempt obligations, as follows: 

Application of $10 million limit 

The bill clarifies that, in applying the $10 million limitation with 
respect to qualified tax-exempt obligations, all tax-exempt obliga- 
tions (other than private activity bonds, as defined above) which 
the issuer reasonably anticipates to issue during the calendar year 
are taken into account. Thus, only an issuer that reasonably antici- 
pates to issue $10 million or less of such obligations during the cal- 



1 This rule is applied after the general disallowance rule applicable to all taxpayers (sec. 
265(a)(2)). 

2 For purposes of this exception only, qualified 501(c)(3) bonds (as defined in Title XIII of the 
Act) are not treated as private activity bonds. Additionally, certain bonds receiving transitional 
exceptions under Title XIII of the Reform Act, and which would not have been industrial devel- 
opment bonds (IDBs) or private loan bonds under prior law, are not treated as private activity 
bonds. 



76 

endar year (including designated and undesignated issues) may des- 
ignate any of these obligations for purposes of the exception. 

Treatment of composite issues 

The bill specifies the treatment of composite issues (i.e., com- 
bined issues of bonds for different entities) for purposes of the ex- 
ception. Under the bill, composite issues qualify for the exception 
only if the requirements of the exception are met (1) with respect 
to the composite issue as a whole (determined by treating the com- 
posite issue as a single issue), and, additionally, (2) with respect to 
each separate lot of obligations which is a part of the issue (deter- 
mined by treating each separate lot of obligations as a separate 
issue). Thus, a composite issue may qualify for the exception only if 
the composite issue itself does not exceed $10 million, and if, addi- 
tionally, each issuer benefiting from the composite issue reasonably 
anticipates to issue not more than $10 million of tax-exempt obliga- 
tions (other than private activity bonds, as described above) during 
the calendar year, including bonds issued through the composite 
arrangement. See also, the conditions under which bonds of differ- 
ent issuers are aggregated for purposes of the $10 million limit, de- 
scribed below. 

Aggregation of issuers 

The bill clarifies the operation of the provision under which an 
issuer and all subordinate entities are aggregated for purposes of 
the $10 million limitation. The following rules are provided: 

(1) An issuer and all entities which issue bonds "on behalf of ^ 
that issuer are to be treated as one issuer. 

(2) If an issuer is subordinate to another entity but does not issue 
bonds on behalf of another entity, bonds issued by the subordinate 
entity are taken into account in applying the $10 million limitation 
to the entity to which it is subordinate. 

(3) If an entity is formed or (to the extent provided in Treasury 
regulations) availed of for purposes of avoiding the $10 million lim- 
itation, such entity and any other entity (or entities) purporting to 
benefit from this device are treated as one issuer. 

Treatment of refunding bonds 

Under the bill, the treatment of refunding bonds is also clarified. 
Specifically, any bond used to refund (other than in an advance re- 
funding) a previously issued bond is not to be taken into account, 
for purposes of applying the $10 million limitation to other, nonre- 
funding bonds. Refunding bonds themselves may qualify for desig- 
nation under the exception for qualified tax-exempt obligations 
only if (1) the refunded bond was designated, qualified for, and was 
taken into account under, the $10 million limitation when issued, 
(2) the aggregate face amount of the issue of which the refunding 
bond is a part does not exceed $10 million, (3) except in the case of 
refundings of bonds having a weighted average maturity of 3 years 
or less, the weighted average maturity of the refunding issue does 
not exceed the weighted average maturity of the refunded bonds. 



■ See, e.g.. Rev. Rul. 63-20, 1963-1 C.B. 24. 



77 

and (4) no bond which is part of the refunding issue has a maturity 
in excess of 30 years (measured from the date of issuance of the 
refunded bonds). 

Designation of certain bonds issued in reliance on House bill 

The bill specifies that only obligations issued after August 7, 

1986, may be designated for purposes of the exception. For obliga- 
tions issued after August 7, 1986, and before January 1, 1987, the 
period for making a designation is not to expire before January 1, 
1988. 

A special rule is provided for certain obligations issued before 
August 8, 1986, in reliance on a similar exception contained in the 
House version of the 1986 Act.^ Under this rule, if (1) an obligation 
was issued after December 31, 1985, and before August 8, 1986, (2) 
when the obligation was issued, the issuer designated that it in- 
tended the obligation to qualify under section 802(e)(3) of the House 
bill, and (3) the issuer reaffirms its election under the 1986 Act, 
then the obligation is treated as issued on August 8, 1986. 

Effective dates 

The provisions regarding aggregation of entities, refundings, and 
composite issues are effective for obligations issued after June 30, 

1987. (At the election of the issuer, these provisions are effective as 
if included in the 1986 Act). Other provisions are effective as if in- 
cluded in the 1986 Reform Act. 



H.R. 3838 (99th Congress), as passed by the House of Representatives on December 17, 1985. 



X. Insurance Provisions (Sees. 110 and 118(g) and (i) of the Bill) 

1. Treatment of certain market discount bonds (sec. 110(a) of the 

bill and sec. 1011(d) of the Reform Act) 

Present Law 

The Reform Act repealed the prior-law 28 percent alternative tax 
rate for corporate long-term capital gains, for years for which the 
new corporate tax rates are fully effective (i.e., taxable years begin- 
ning on or after July 1, 1987). Thus, corporate net capital gain for 
such years is taxed at regular corporate rates (i.e., generally a max- 
imum 34 percent rate under the Reform Act). For taxable years 
that include periods prior to the time the new rates are fully effec- 
tive, the alternative tax rate under the Reform Act on gain proper- 
ly taken into account under the taxpayer's method of accounting 
after December 31, 1986, is 34 percent. These rules apply to all 
items of long term capital gain, including gain attributable to 
market discount on bonds issued before July 19, 1984, which was 
treated as long-term capital gain under the transition rules of the 
Deficit Reduction Act of 1984. 

The Deficit Reduction Act of 1984 generally required income at- 
tributable to market discount to be treated as ordinary income 
rather than capital gain on disposition of a bond (Code sec. 1276). 
However, the 1984 Reform Act grandfathered market discount gain 
on bonds issued before July 19, 1984. 

Under the Reform Act, a special rule is provided for gain with 
respect to certain bonds of certain specified life insurance compa- 
nies. Pursuant to this rule, gain representing market discount rec- 
ognized by such companies on the redemption at maturity of any 
bond which was issued before July 19, 1984, and acquired by the 
company on or before September 25, 1985, is subject to tax at the 
rate of 28 percent. 

Explanation of Provision 

The bill extends the special rule under the Reform Act to all life 
insurance companies with a modification of the tax rate. Under the 
bill, the tax rate on gain subject to the special rule is 31.6 percent, 
rather than 28 percent. 

2. Status of certain organizations providing commercial-type in- 

surance (sec. 110(b) of the bill and sec. 1012 of the Reform 
Act) 

Present Law 

Under present law, an organization described in sections 501(c)(3) 
or (4) of the Code is exempt from tax only if no substantial part of 
its activities consists of providing commercial-type insurance. In 

(78) 



79 

the case of such a tax-exempt organization, the activity of provid- 
ing commercial-type insurance is treated as an unrelated trade or 
business but, in lieu of the usual tax on unrelated trade or business 
taxable income, the unrelated trade or business activity is taxed 
under the rules relating to insurance companies (subchapter L of 
the Code). 

Commercial-type insurance does not include insurance provided 
at substantially below cost to a class of charitable recipients. Com- 
mercial-type insurance also does not include health insurance pro- 
vided by a health maintenance organization (i.e., any health main- 
tenance organization, tax-exempt under prior law, which is sub- 
stantially the same as a Federally chartered health maintenance 
organization), if such health insurance is of a kind customarily pro- 
vided by such organizations and is incidental to the organization's 
principal activity of providing health care. Commercial-type insur- 
ance also does not include property and casualty insurance provid- 
ed by certain church organizations or conventions or associations of 
churches, if certain requirements are met. 

The provision does not apply to certain organizations, including 
Delta Dental Plans Association and the Missouri Hospital Associa- 
tion. 

Explanation of Provision 

The exceptions from the provision for Delta Dental Plans Asso- 
ciation and for the Missouri Hospital Association are restated to 
apply to Delta Dental Plans Association organizations and to the 
Missouri Hospital Plan, respectively. 

The bill also provides Treasury regulatory authority to prescribe 
rules providing proper adjustments in the case of organizations 
that have a fiscal taxable year and that become subject to tax by 
reason of the provision, where the organization has a short taxable 
year that begins during 1987 by reason of rules requiring property 
and casualty insurance companies generally to have a calendar 
taxable year. 

3. Inclusion in income of 20 percent of unearned premium reserve 
(sec. 110(c) of the bill, sec. 1021 of the Reform Act, and sec. 
832(b)(7) of the Code) 

Present Law 

Present law, as amended by the Reform Act, provides that a 
property and casualty insurance company generally is required to 
reduce its deduction for increases in unearned premiums by 20 per- 
cent. In addition, such companies are required to include in income 
20 percent of the unearned premium reserve outstanding at the 
end of the most recent taxable year beginning before January 1, 
1987, ratably over the 6 taxable years following such year. 

The provision requiring ratable inclusion of the pre- 1987 un- 
earned premium reserve applies to a company without regard to 
whether the company had computed its taxable income by taking 
into account additions to an unearned premium reserve. Thus, the 
ratable inclusion rule applies, under the Reform Act, to organiza- 



80 

tions that were exempt from Federal income tax prior to 1987 and 
to small companies that were taxed solely on investment income. 
The Reform Act did not provide special rules for reciprocal insur- 
ers. 

Explanation of Provision 

Treatment of certain formerly exempt companies. — The bill pro- 
vides that if, at all times prior to its 1987 taxable year, a company 
was exempt from tax under section 501(a) by virtue of being de- 
scribed in a paragraph of section 501(c), or was a small company 
subject to tax only on investment income, then the ratable inclu- 
sion rule does not apply. This clarification reflects the intent that 
no inclusion of prior reserve amounts is appropriate if the company 
received no tax benefit from the reserve amounts due to its former 
fully or partially tax-exempt status. 

Phase-in treatment. — The bill also adjusts the period over which 
inclusion of 20 percent of the outstanding balance of the unearned 
premium reserve is required in the case of a company that (1) is 
exempt from tax under section 501(a) by virtue of being described 
in any paragraph of section 501(c), or is subject to tax only on in- 
vestment income for its first taxable year beginning after 1986; and 
(2) was subject to tax as a property and casualty insurance compa- 
ny in a year beginning before 1987. Such companies generally com- 
puted taxable income taking into account a reserve for the gross 
amount of unearned premiums. In such a case, the 20 percent rata- 
ble inclusion rule applies for the 6-year period that begins with the 
first taxable year after 1986 in which the company is subject to tax 
under section 831(a). 

Treatment of reciprocal insurers. — The bill provides that, in the 
case of an interinsurer or reciprocal underwriter (within the mean- 
ing of sec. 835) that is required under applicable State law to report 
on its annual statement reserves on unearned premiums net of pre- 
mium acquisition expenses, the amount of the unearned premiums 
is to be treated as including an amount equal to such expenses for 
purposes of the decrease in the deduction for unearned premiums. 
Otherwise, such taxpayers would be subject to ratable inclusion of 
a portion of the unearned premium reserve that did not give rise to 
mismatching of income and deductions under prior law, which the 
ratable inclusion rule was intended to address. 

4. Treatment of certain dividends and tax-exempt interest (sec. 
110(d) of the bill, sec. 1022 of the Reform Act, and sec. 
832(b)(5) of the Code) 

Present Law 

Present law, as amended by the Reform Act, provides that the 
deduction of a property and casualty company for losses incurred is 
reduced by 15 percent of (1) the property and casualty insurance 
company's tax-exempt interest and (2) the deductible portion of 
dividends received (with special rules for dividends from affiliates). 
For purposes of this proration provision, tax-exempt interest in- 
cludes interest income excludable under section 103 (or deductible 
under sec. 832(c)(7)), the portion of interest income excludable 



81 

under section 133, and other similar items. If the amount of this 
reduction exceeds the amount otherwise deductible as losses in- 
curred, the excess is includible in income. 

Explanation of Provision 

The bill clarifies the treatment of dividends received for purposes 
of applying the proration provision in the case of a property and 
casualty insurance company that files a consolidated return. Under 
the bill, the determination with respect to any dividend paid by a 
member to another member of the affiliated group filing the con- 
solidated return is made as if the group were not filing a consoli- 
dated return. 

The bill also clarifies that the deductible portion of any dividends 
received from a subsidiary, including those received directly or in- 
directly from a lower tier subsidiary, are subject to the proration 
rules in the hands of the property and casualty insurance affiliate. 
These provisions conform to the application of the proration rules 
generally to all property and casualty insurance companies. 

5. Loss reserves (sec. 110(e) of the bill, sec. 1023 of the Reform 
Act, and sec. 846 of the Code) 

Present Law 

The Reform Act provides for the discounting of the deduction for 
additions to loss reserves of property and casualty insurance com- 
panies to take account partially of the time value of money. The 
discounting of such deductions is applicable to loss reserves of prop- 
erty and casualty companies, and to loss reserves of life insurance 
companies that are not required to be discounted under life insur- 
ance reserve rules. Special rules are provided in the case of certain 
accident and health, international, and reinsurance lines of busi- 
ness. The discounting of loss reserves is effective for taxable years 
beginning after 1986, with a fresh start provision with respect to 
undiscounted loss reserves applicable to the last taxable year be- 
ginning before 1987. 

Explanation of Provisions 

The bill clarifies that, with respect to the special rule for dis- 
counting unpaid loss reserves in certain accident and health lines 
of business (other than unpaid losses relating to disability income), 
it is assumed that unpaid losses are paid in the middle of the year 
following the accident year. This assumption is intended to con- 
form to the general assumption for loss reserve discounting pur- 
poses that losses are paid in the middle of the year. 

The bill provides that the Secretary may prescribe regulations to 
determine appropriate adjustments in the application of the unpaid 
loss discounting provisions, in the case of a taxpayer having a tax- 
able year other than the calendar year. Although most property 
and casualty companies have a calendar taxable year, some compa- 
nies filing a consolidated return with noninsurance companies will 
have a fiscal taxable year. The Reform Act did not provide special 
rules that are used in applying the discounting rules to such fiscal 
year taxpayers. 



82 

The regulations also should provide appropriate adjustments in 
the application of the discounting provisions in cases where the 
Reform Act resulted in a required change in a company's period of 
accounting (e.g., where the Reform Act results in the application 
for the first time of sec. 843, which generally requires property and 
casualty insurance companies to utilize a calendar taxable year). 

The bill also clarifies the application of the fresh start provision 
in the case of an insurance company that (1) is exempt from tax 
under section 501(a) by virtue of being described in any paragraph 
of section 501(c) or, under section 831(b), is taxed only on invest- 
ment income, in a year beginning after 1986, and (2) later becomes 
subject to tax under section 831(a) as a regular property and casu- 
alty insurance company. The rules relating to the fresh start under 
the discounting provisions are to be applied by treating the last 
taxable year before the year in which such a company becomes 
subject to tax under sec. 831(a) as the company's last taxable year 
beginning before 1987. 

6. Election to be taxed only on investment income (sec. 110(f) of 

the bill, sec. 1024 of the Reform Act, and sec. 831(b) of the 
Code) 

Present Law 

The Reform Act provided that mutual and stock property and 
casualty insurance companies with net written premiums or direct 
written premiums (whichever is greater) in excess of $350,000, but 
less than $1,200,000, may elect to be taxed only on taxable invest- 
ment income. 

Explanation of Provisions 

The bill clarifies that the election to be taxed only on investment 
income, once made and so long as the requirements for the election 
are met, may be revoked only with the consent of the Secretary. 
This clarification reflects Congress' intent that the election not be 
used as a means of eliminating tax liability (e.g., by making the 
election only for years when the taxpayer does not have net operat- 
ing losses), but rather as a simplification for small companies. 

7. Treatment of Physicians' and Surgeons' Mutual Protection As- 

sociations (sec. 110(g) of the bill and sec. 1031 of the Reform 

Act) 

Present Law 

Under the Reform Act, initial contributions to a pooled malprac- 
tice insurance association are currently deductible to the extent 
they do not exceed the cost of a commercial insurance premium for 
annual coverage and are included in the association's income. Re- 
funds of such contributions are deductible to the fund only to the 
extent included in the income of the recipient. The Reform Act pro- 
vision applies to associations operating under State law prior to 
January 1, 1984. 



83 

Explanation of Provision 

The bill clarifies that initial contributions to a pooled malprac- 
tice insurance association under the provision include otherwise 
qualifying contributions whether paid all in one year or in up to 
six annual installments, provided, of course, that the total amount 
of the contribution does not exceed the cost of a commercial insur- 
ance premium for annual coverage. Members of the association are 
intended to include provisional members (i.e., those association 
members who have paid one or more, but not all, of the annual in- 
stallments of their initial contribution). 

8. Special rule for mutual life insurance company (sec. 110(h) of 

the bill and sec. 217(1) of the Deficit Reduction Act of 1984) 

Present Law 

The Deficit Reduction Act of 1984 provided that a mutual life in- 
surance company may elect to treat all individual noncancellable 
(or guaranteed renewable) accident and health contracts as 
through they were cancellable for purposes of determining under 
section 816 whether or not it is subject to tax as a life insurance 
company or a property and casualty insurance company. Stock life 
insurance subsidiaries of electing mutual companies are treated as 
though they were mutual life insurance companies. 

Explanation of Provision 

The bill provides that, for purposes of determining the amount of 
the small life insurance company deduction of a controlled group 
including an electing mutual company, the taxable income of the 
electing company is taken into account in applying the phaseout of 
the small life insurance company deduction, for taxable years be- 
ginning after 1986 and before 1992. The bill further provides that 
the decrease in the amount of Federal revenue by reason of this 
provision shall not exceed $300,000 per taxable year. 

9. Annuity diversification requirements (sec. llO(i) of the bill, sec. 

1821(m) of the Reform Act, and sec. 817(h) of the Code) 

Present Law 

Present law provides that certain variable contracts that are 
based on a segregated asset account generally are not treated as 
annuity contracts if the investments made by such account are not 
(as provided in Treasury regulations) adequately diversified. No 
special rule is provided for immediate annuities. Treasury regula- 
tions were published September 12, 1986, setting forth require- 
ments for adequate diversification of certain variable contracts, in- 
cluding immediate annuities. 

Explanation of Provision 

The bill provides additional time to comply with the annuity di- 
versification requirement, in the case of variable contracts that are 
immediate annuities (as defined in sec. 72(u)(4)) that were issued by 
September 12, 1986, and that do not (as of that date) meet the di- 



84 

versification requirements set forth in the September 12, 1986, reg- 
ulations because the investments made by the segregated asset ac- 
counts under the contracts were invested in Government-guaran- 
teed investments (FDIC- or FSLIC-guaranteed deposits). In such 
cases, the diversification requirement with respect to Government 
securities (including Government-guaranteed investments) is 
waived until December 31, 1988, but applies in full on and after 
January 1, 1989. 

10. Treatment of alternative minimum tax with respect to share- 

holders surplus account (sec. 110(j) of the bill and sec. 815(c) 
of the Code) 

Present Law 

Present law provides that, in the case of a stock life insurance 
company having an existing policyholder surplus account, a share- 
holders surplus account must be continued in order to maintain a 
record for tax purposes of amounts eligible for distribution before a 
distribution is made from the policyholders surplus account (and, 
generally, treated as taxable to the distributing company). In gen- 
eral, the excess of the following amounts over the taxes paid for 
the year are added to the shareholders surplus account: (1) life in- 
surance company taxable income (but not below zero); (2) the small 
life insurance company deduction; (3) the dividends received deduc- 
tion allowed; and (4) excluded tax-exempt interest. 

Explanation of Provision 

The bill provides that, under regulations, in determining addi- 
tions to the shareholders surplus account, proper adjustments are 
to be made for any year in which alternative minimum tax is im- 
posed under section 55 of the Code and for all subsequent years. 
The provision was intended to take account, in calculating the 
amount in the shareholders surplus account, of net tax liability of 
the company, and thus should take into account minimum tax and 
the minimum tax credit. 

11. Treatment of certain items as not interest for source rules 
(sec. llO(k) of the bill, sec. 1215 of the Reform Act, and sec. 
818(f) of the Code) 

Present Law 

The Reform Act's legislative history indicates that deductions of 
life insurance companies that are described in Code section 
807(c)(1), (2), (3), and (6) should not be treated as interest expenses, 
under the source rules, for allocation purposes (new Code sec. 
864(e), added by section 1215 of the Reform Act). This language 
could lead to the inference that deductions described in section 
807(c)(4) and (5) are interest expenses for allocation purposes. 

Explanation of Provision 

The bill clarifies that deductions of life insurance companies that 
are described in Code section 807(c) (which includes paragraphs (1) 
through (6)) are not to be treated as interest expenses for allocation 



85 

purposes under new Code section 864(e), added by section 1215 of 

the Reform Act. 

12. Technical corrections to the Deficit Reduction Act of 1984 
(sees. 118(g) and (i) of the bill, sees. 1821 and 1825(a)(4) of the 
Reform Act, and sees. 812(e) and 7702 of the Code) 

Present Law 

Determination of policyholders^ share of gross investment 
income. — Present law provides that the policyholders' share of tax- 
exempt interest reduces a life insurance company's deduction for 
certain reserves. For purposes of determining the policyholders' 
share, sec. 812(e) provides that gross investment income excludes 
any dividend received by the life insurance company that is a 100- 
percent dividend. Whether a dividend is a 100-percent dividend is 
determined by reference to the definition in sec. 805(a)(4)(C), not in- 
cluding dividends described in sec. 805(a)(4)(D). The Reform Act 
modified the provisions of sees. 805(c)(4)(C) and (D). 

Certain policies to cover burial or funeral expenses. — Present law, 
as amended by the Reform Act, provides that future increases in 
death benefits may be taken into account in determining whether 
the definition of a life insurance contract is satisfied with respect 
to certain policies to cover payment of burial expenses or in con- 
nection with prearranged funeral expenses. Such contracts can 
qualify as life insurance contracts, provided that certain require- 
ments (relating to limitations on increases in the death benefit) are 
satisfied. The Reform Act provided no specific effective date for the 
provision. 

Explanation of Provisions 

Determination of policyholders' share of gross investment 
income. — The bill clarifies that the prior-law definition of 100-per- 
cent dividends continues to apply for purposes of determining gross 
investment income within the meaning of section 812. Thus, the 
provision is intended to retain the definition as under prior law. 

Certain policies to cover burial or funeral expenses. — The bill pro- 
vides that the rule that future increase in death benefits may be 
taken into account under the definition of a life insurance contract, 
with respect to certain policies to cover payment of burial expenses 
or in connection with prearranged funeral expenses, is effective for 
contracts entered into on or after October 22, 1986. Congress in- 
tended that the provision be prospectively effective. 



XL Pensions and Deferred Compensation; Employee Benefits; 
ESOPs (Sees. Ill, lllA, lllB, and 118(q) of the Bill) 

A. Limitations on Treatment of Tax-Favored Savings 

1. Individual retirement arrangements (IRAs) (sec. 111(a) and (b) 
of the bill, sees. 1101 and 1102 of the Reform Act, and sees. 
219, 408, 4973, and 6693 of the Code) 

a. IRA deduction limit 

Present Law 

Under present law (sec. 219), a taxpayer is permitted to make de- 
ductible IRA contributions up to the lesser of $2,000 or 100 percent 
of compensation (earned income in the case of a self-employed indi- 
vidual) if: 

(1) in the case of a taxpayer who is not married or is married but 
files a separate return, the taxpayer either (a) has adjusted gross 
income (AGI) that does not exceed the applicable dollar amount or 
(b) is not an active participant in an employer-maintained retire- 
ment plan for any part of the plan year ending with or within the 
taxable year; or 

(2) in the case of married taxpayers filing a joint return, either 
(a) the couple has AGI that does not exceed the applicable dollar 
amount or (b) neither spouse is an active participant in an employ- 
er-maintained retirement plan for any part of the plan year ending 
with or within the taxable year. 

The applicable dollar amount is (1) $25,000, in the case of an un- 
married individual, (2) $40,000, in the case of a married couple 
filing a joint return, and (3) $0, in the case of a married taxpayer 
filing separately. The otherwise applicable IRA dollar limit (i.e., 
$2,000) is reduced by an amount that bears the same ratio to such 
dollar limit as the taxpayer's AGI in excess of the applicable dollar 
amount (or, in the case of a married couple filing a joint return, 
the couple's AGI in excess of the applicable dollar amount) bears to 
$10,000. 

Explanation of Provision 

Present law creates an unintended incentive for married couples 
to file separate returns. If one spouse is an active participant and 
the other spouse is not, the couple can increase their IRA deduc- 
tion limit under certain circumstances by filing separate returns. 

In order to eliminate this incentive for a married couple living 
together, the bill provides that, for purposes of determining wheth- 
er an IRA contribution is deductible for a taxable year, if the 
couple lives together at any time during the year, the active partic- 
ipant status of both spouses is taken into account for purposes of 

(86) 



87 

calculating the IRA deduction limit. If the spouses file separate re- 
turns, the applicable dollar amount is $0 and only the AGI of the 
spouse making the IRA contribution is taken into account. 

Also under the bill, a taxpayer is not considered married for a 
year if the taxpayer and the taxpayer's spouse (1) did not live to- 
gether at any time during the taxable year, and (2) did not file a 
joint return for the taxable year. A taxpayer meeting these re- 
quirements for a taxable year is treated as an unmarried individ- 
ual for the taxable year. Accordingly, for purposes of determining 
the taxpayer's deduction limit, only the taxpayer's AGI and status 
as an active participant is taken into account, and the applicable 
dollar amount is $25,000. 

b. Nondeductible IRA contributions 
Present Law 

Under present law, an individual is permitted to make designat- 
ed nondeductible IRA contributions to the extent that deductible 
contributions are not allowed due to the AGI phaseout for active 
participants. In addition, a taxpayer may elect to treat otherwise 
deductible IRA contributions as nondeductible. 

An individual who makes a designated nondeductible contribu- 
tion to an IRA for a taxable year or who receives a distribution 
from an IRA during a taxable year is required to provide such in- 
formation as the Secretary may prescribe on the individual's tax 
return for the taxable year and, to the extent required by the Sec- 
retary, for succeeding taxable years (or on such other form as the 
Secretary may prescribe). The information that may be required in- 
cludes, but is not limited to, (1) the amount of designated nonde- 
ductible contributions for the taxable year, (2) the amount of distri- 
butions from individual retirement plans for the taxable year, (3) 
the aggregate amount of designated nondeductible contributions for 
all preceding taxable years which have not previously been with- 
drawn, and (4) the aggregate balance of all IRAs of the individual 
as of the close of the calendar year with or within which the tax- 
able year ends. An individual who overstates the amount of desig- 
nated nondeductible contributions for a year is subject to a penalty 
of $100 for each overstatement unless it is shown that the over- 
statement is due to reasonable cause. 

Explanation of Provision 

Under present law, there is no separate penalty with respect to 
an individual who fails to file the form prescribed by the Secretary 
with respect to nondeductible IRA contributions. Accordingly, 
under the bill, a taxpayer who fails to file the form required by the 
Secretary is subject to a penalty of $50 for each such failure unless 
the taxpayer shows that the failure is due to reasonable cause. 

In order to take into account taxpayers with fiscal year taxable 
years, the bill provides that the information that the Secretary 
may require to be included on the form or return includes the ag- 
gregate balance of all IRAs of the individual as of the close of the 
calendar year in which the taxable year begins (rather than the 
calendar year with or within which the taxable year ends). 



88 

c. IRA withdrawals 

Present Law 

Present law provides that amounts withdrawn from an IRA 
during a taxable year are includible in income for the taxable year 
under rules similar to the rules applicable to qualified plans under 
section 72. Under special rules applicable to IRAs for purposes of 
section 72, (1) all IRAs of an individual (including rollover IRAs 
and simplified employee pensions (SEPs), but excluding deductible 
qualified voluntary employee contributions) are treated as 1 con- 
tract, (2) all distributions that are made during a taxable year are 
treated as 1 distribution, (3) the value of the contract (calculated 
after adding back distributions that are made during the year), 
income on the contract, and investment in the contract are com- 
puted as of the close of the calendar year with or within which the 
taxable year ends, and (4) the aggregate amount of withdrawals ex- 
cludable from income for all taxable years shall not exceed the tax- 
payer's investment in the contract for all taxable years. 

Explanation of Provision 

Under the bill, for purposes of applying the special IRA rules of 
section 72, the value of the contract (calculated after adding back 
distributions that are made during the year), income on the con- 
tract, and investment in the contract are computed as of the close 
of the calendar year in which the taxable year begins (rather than 
the calendar year with or within which the taxable year ends). The 
provision is intended to facilitate computations with respect to tax- 
payers with fiscal year taxable years. 

d. Excess contributions 

Present Law 
Distribution prior to due date of return 

Under present law (sec. 408(d)(4)), the normal rules for the tax- 
ation of distributions (sec. 72) do not apply to a distribution of con- 
tributions to an IRA (and, consequently, the contributions are not 
taxed upon distribution) if (1) the contributions exceed the amount 
allowable as a deduction under section 219, (2) the distribution is 
received on or before the due date (including extensions) for the in- 
dividual's return for the taxable year, (3) no deduction is allowed 
under section 219 with respect to the excess contributions, and (4) 
the distribution is accompanied by the amount of net income at- 
tributable to the excess contributions. The net income on the con- 
tributions is deemed to have been earned and receivable in the tax- 
able year in which the excess contributions were made. 

Distribution after due date of return 

If the total contributions made to all IRAs for a year (excluding 
rollover IRAs) does not exceed $2,250, then, under present law, the 
normal rules for the taxation of distributions (sec. 72) do not apply 
to a distribution of contributions in excess of the amount allowable 
as a deduction under section 219 if the excess contributions are dis- 



89 

tributed after the due date (including extensions) for filing the indi- 
vidual's tax return for the year the contributions were made (sec. 
408(d)(5)). For purposes of this rule, the amount allowable as a 
deduction under section 219 (after application of section 
408(o)(2)(B)(ii)) is increased by the nondeductible limit under section 
408(o)(2)(B). 

Excise tax 

Present law provides a 6-percent nondeductible excise tax on con- 
tributions to an IRA in excess of the amount allowable as a deduc- 
tion under section 219 for a taxable year, if the excess contribu- 
tions are not timely distributed (sec. 4973(b)). For purposes of this 
rule, the amount allowable as a deduction under section 219 (after 
application of section 408(o)(2)(B)(ii)) is increased by the nondeduct- 
ible limit under section 408(o)(2)(B). 

Explanation of Provision 
Distribution prior to due date of return 

The bill amends the rules relating to distributions of excess con- 
tributions to take into account the fact that nondeductible contri- 
butions may be made to an IRA. The bill permits any IRA contri- 
butions to be distributed without income or excise tax consequences 
prior to the due date (including extensions) for filing the individ- 
ual's income tax return for the year the contributions are made. 
Thus, under the bill, the normal rules for the taxation of IRA dis- 
tributions do not apply to a distribution of any contributions to an 
IRA if (1) the distribution is received on or before the due date (in- 
cluding extensions) for the individual's return for the taxable year 
for which the contributions were made, (2) no deduction is allowed 
under section 219 with respect to the contributions, and (3) the dis- 
tribution is accompanied by the amount of net income attributable 
to the contributions. As under present law, net income on the con- 
tributions are deemed to have been earned and receivable in the 
taxable year in which the contributions were made. 

Distribution after due date of return 

The bill clarifies the intent that certain IRA contributions not in 
excess of $2,250 may be withdrawn by providing that, for purposes 
of the rule relating to return of excess contributions after the due 
date of the individual's return for the year for which the contribu- 
tions were made, the amount allowable as a deduction under sec- 
tion 219 is computed without regard to the AGI phaseout for active 
participants (sec. 219(g)). 

Excise tax 

The bill provides that, for purposes of the excise tax on excess 
contributions to an IRA, the amount allowable as a deduction 
under section 219 is computed without regard to the AGI phaseout 
for active participants (sec. 219(g)). 



90 

2. Qualified cash or deferred arrangements (sec. 111(c) and (1) of 
the bill, sees. 1105 and 1116 of the Reform Act, and sees. 
401(k), 402, and 4979 of the Code) 

a. Limit on elective deferrals 

Present Law 

In general 

Present law provides that the maximum amount that an employ- 
ee can elect to defer for any taxable year under all cash or deferred 
arrangements in which the employee participates is limited to 
$7,000. This $7,000 limit is adjusted for inflation at the same time 
and in the same manner as the indexing of the dollar limit on ben- 
efits under section 415(d). The $7,000 limit applies to the employ- 
ee's taxable year, regardless of the employer's taxable year or the 
plan year applicable to the cash or deferred arrangement. The 
$7,000 limit is coordinated with other plans to which elective defer- 
rals are made. 

To ease the administrative burden on employees, employers, and 
the IRS, the elective deferral arrangements maintained by any 
single employer may preclude an employee from making elective 
deferrals under such arrangements for a taxable year in excess of 
$7,000. 

Treatment of excess deferrals 

If, for any taxable year, the total amount of elective deferrals 
contributed on behalf of an employee to all qualified cash or de- 
ferred arrangements and other plans subject to the limit in which 
the employee participates exceeds $7,000, then the amounts in 
excess of $7,000 (the excess deferrals) are included in the employ- 
ee's gross income for the taxable year to which the deferral relates. 
In addition, with respect to any excess deferrals, by March 1 after 
the close of the employee's taxable year, the employee may allocate 
the excess deferrals among the qualified cash or deferred arrange- 
ments and other plans subject to the limit in which the employee 
participates and notify the administrator of each plan of the por- 
tion of the excess deferrals allocated to that plan. Not later than 
April 15 after the close of the employee's taxable year, each plan 
may (but is not required to) distribute to the employee the amount 
of the excess deferrals (plus income attributable to the excess defer- 
rals) allocated to the plan. 

The distribution may be made without regard to the terms of the 
plan until the close of the first plan year for which an amendment 
is required (Act sec. 1140) and notwithstanding any other provision 
of law. In addition, the Secretary is to prescribe a model plan 
amendment which permits the distribution of excess deferrals. Dis- 
tribution pursuant to such amendment is to be treated as in ac- 
cordance with the plan. 

Income on excess deferrals distributed by the applicable April 15 
date is treated as earned and received in the taxable year to which 
the excess deferral relates. Excess deferrals (and earnings thereon) 
distributed by the applicable April 15 date are not subject to the 
additional income tax on early withdrawals (sec. 72(t)). Deferrals 



91 

are not subject to the 10-percent excise tax on nondeductible contri- 
butions (sec. 4972) merely because they are excess deferrals. 

Reporting requirements 

Under the Act, the employer is required to report to an employee 
and to the IRS the amount of elective deferrals made by the em- 
ployee and the amount of compensation deferred under section 457 

(sec. 6051(a)). 

Explanation of Provision 

In general 

The bill provides that income on excess deferrals is includible in 
gross income in the year distributed, rather than in the year of the 
deferral. To prevent individuals from electing to make excess defer- 
rals in order to defer current taxation of income, the bill requires, 
as a condition of qualification, that a plan that has a cash or de- 
ferred arrangement is required to provide that elective deferrals 
under the arrangement and under all other plans, contracts, or ar- 
rangements of the employer maintaining the plan for a calendar 
year may not exceed the limitation on elective deferrals in effect 
for taxable years beginning in such calendar year. A similar re- 
striction is required to be included in a simplified employee pen- 
sion (SEP) (sec. 408(k)), tax-sheltered annuity contract (sec. 403(b)), 
or section 501(c)(18) plan that permits elective deferrals. The provi- 
sion is generally effective with respect to plan years beginning 
after December 31, 1987. A delayed effective date applies with re- 
spect to employees who participate in a plan maintained pursuant 
to a collective bargaining agreement if the employees are covered 
by the bargaining agreement. 

Treatment of excess deferrals 

Under the bill, income on excess deferrals distributed before the 
applicable April 15 date, including income earned during and after 
the year to which the deferral relates, is includible in income in 
the year distributed, rather than in the year to which the deferral 
relates. The bill clarifies that any distribution of less than the 
entire amount of excess deferrals plus income attributable to such 
deferrals is treated as a pro rata distribution of excess deferrals 
and income. 

The bill clarifies that excess deferrals (and income on such defer- 
rals) distributed by the applicable April 15 are not subject to the 
15-percent tax on excess distributions (sec. 4980A). 

Reporting requirements 

The Act did not contain an effective date for the reporting re- 
quirement relating to elective deferrals. The reporting requirement 
was intended to be effective at the same time the Act's limit on 
elective deferrals was effective. Accordingly, the bill provides that 
the requirement is effective with respect to calendar years begin- 
ning after December 31, 1986. 



92 
b. Nondiscrimination requirements 
Present Law 

Under present law, a special nondiscrimination test applies to 
limit the elective deferrals that may be made by highly compensat- 
ed employees. The limit depends (in part) on the level of elective 
deferrals by nonhighly compensated employees. A cash or deferred 
arrangement under which only highly compensated employees par- 
ticipate or are eligible to participate does not satisfy the special 
nondiscrimination test. For purposes of applying the special nondis- 
crimination test, under rules prescribed by the Secretary, employer 
matching contributions that are nonforfeitable and that satisfy cer- 
tain withdrawal restrictions may be taken into account. 

If the special nondiscrimination rules are not satisfied for any 
year, present law provides that the qualified cash or deferred ar- 
rangement will not be disqualified if the excess contributions (plus 
income allocable to the excess contributions) are distributed before 
the close of the following plan year. In addition, instead of receiv- 
ing an actual distribution of excess contributions, an employee may 
elect to have the excess contributions treated as an amount distrib- 
uted to the employee and then recontributed by the employee to 
the plan on an after-tax basis. Such recharacterization is not per- 
mitted in the absence of regulations. A plan may provide that an 
employee is required to make such a recharacterization election as 
a condition of plan participation. 

Distribution of excess contributions may be made notwithstand- 
ing any provision of the plan until the first plan year for which 
plan amendments are required (Act sec. 1140) and notwithstanding 
any other provision of law. In addition, the Secretary is to pre- 
scribe a model plan amendment that permits the distribution of 
excess deferrals. Distribution pursuant to such amendment is to be 
treated as a distribution made in accordance with the plan. The 
amount distributed is not subject to the 10-percent additional 
income tax on early v/ithdrawals (sec. 72(t)). Contributions are not 
subject to the 10-percent excise tax on nondeductible contributions 
(sec. 4972) merely because they are excess contributions. 

Prior to the Deficit Reduction Act of 1984 (DEFRA), proposed 
Treasury regulations permitted a cash or deferred arrangement 
that failed the special nondiscrimination test to be qualified if the 
arrangement satisfied the general nondiscrimination rules (sec. 
401(a)(4)). DEFRA provided that a cash or deferred arrangement is 
not qualified unless it satisfies the special nondiscrimination test 
(with an exception provided in DEFRA sec. 527(c)(1)(B)). Although 
the Act modified the nondiscrimination requirements, it did not 
change the rule enacted in DEFRA section 527(c)(1)(B). 

For a discussion of the excise tax on excess contributions and 
excess aggregate contributions (sec. 4979), see below. 

Explanation of Provision 

The bill clarifies that, for purposes of the special nondiscrimina- 
tion test, the elective deferrals of eligible highly compensated em- 
ployees, rather than all highly compensated employees are taken 
into account. Under prior law, highly compensated employees were 



93 

defined by reference to eligible employees. However, the new uni- 
form definition of highly compensated employees does not refer to 
eligible employees and, therefore, the clarification is necessary to 
obtain a result consistent with prior law. ' 

The bill provides that, for purposes of determining whether 
matching contributions may be used to satisfy the special nondis- 
crimination test for elective deferrals, a matching contribution is 
not treated as forfeitable merely because the matching contribution 
is forfeited because the contribution to which it relates is an excess 
deferral (sec. 402(g)(2)(A)), an excess contribution (sec. 401(k)(8)(B)), 
or an excess aggregate contribution (sec. 401(m)(6)(B)). The bill 
clarifies that excess contributions distributed (or treated as distrib- 
uted) by the end of the plan year following the year the excess con- 
tributions arose are not subject to the excise tax on excess distribu- 
tions (sec. 4980A). 

c. Withdrawal restrictions 

Present Law 

Under present law, withdrawals generally are not permitted 
under a qualified cash or deferred arrangement prior to death, dis- 
ability, separation from service, or (except in the case of a pre- 
ERISA money purchase pension plan or a rural electric cooperative 
plan) the attainment of age 59-1/2. However, a qualified cash or de- 
ferred arrangement (other than a pre-ERISA money purchase pen- 
sion plan or a rural electric cooperative plan) may permit hardship 
withdrawals up to the amount of the employee's elective deferrals 
(but not income on the elective deferrals). 

In addition, under the Act, distributions may be made from a 
qualified cash or deferred arrangement upon (1) termination of the 
plan without the establishment of a successor plan, (2) the date of 
sale by a corporation of substantially all of the assets used by the 
corporation in a trade or business if the employee continues em- 
ployment with the corporation acquiring the assets, or (3) the date 
of the sale by a corporation of the corporation's interest in a sub- 
sidiary if the employee continues employment with the subsidiary. 
The Statement of Managers for the Act provided that a distribu- 
tion upon any of these 3 events is permitted only if the distribution 
constitutes a total distribution of the employee's balance to the 
credit in the cash or deferred arrangement. 

Explanation of Provision 

As originally enacted, the exception to the withdrawal restric- 
tions for certain sales of assets or subsidiaries is unduly restrictive, 
as it does not encompass other transactions that have the effect of 
sales of assets or subsidiaries. The bill expands the exception to in- 
clude dispositions of assets or subsidiaries other than sales and 
clarifies that the exception only applies if the transferor corpora- 
tion continues to maintain the plan after the disposition. Thus, the 
bill provides that distributions can be made from a qualified cash 
or deferred arrangement on the (1) disposition by a corporation of 
substantially all of the assets (within the meaning of sec. 409(d)(2)) 
used by such corporation if the employee continues employment 



94 

with the transferor corporation and the transferor corporation con- 
tinues to maintain the plan, or (2) disposition by a corporation of 
the corporation's interest in a subsidiary (within the meaning of 
sec. 409(d)(3)) if the employee continues employment with the sub- 
sidiary and the transferor corporation continues to maintain the 
plan. 

The bill incorporates statutorily the requirement that a distribu- 
tion must be a total distribution in order for the exception for dis- 
positions of assets or subsidiaries or termination of a plan to apply. 
Under the bill, a distribution upon any of these 3 events is permit- 
ted only if the distribution is a "lump sum distribution". For this 
purpose, "lump sum distribution" means a lump-sum distribution 
under the income averaging rules (sec. 402(e)(4)), but without 
regard to (1) the required events (such as attainment of age 59-1/2) 
for eligibility for income averaging, (2) the election requirement, 
and (3) the minimum period of plan participation requirement. 
Thus, for this purpose, a distribution can constitute a lump sum 
distribution even though, for example, the employee receives the 
distribution prior to age 59-1/2, has already elected lump sum 
treatment for a prior distribution, or has not been a participant in 
the plan for at least 5 years. 

d. Other restrictions 

Present Law 

Under the Act, a cash or deferred arrangement is not qualified if 
any employer contributions or benefits (other than matching con- 
tributions) are conditioned (either directly or indirectly) upon an 
employee's elective deferrals. The Statement of Managers provides 
that this prohibition is not limited to employer-provided benefits. 

The Act prohibits tax-exempt organizations and State and local 
governments (or a political subdivision of a State or local govern- 
ment) from establishing qualified cash or deferred arrangements. 
The restriction does not apply to a rural electric cooperative plan. 

In addition, the prohibition does not apply to plans adopted 
before (1) May 6, 1986, in the case of an arrangement maintained 
by a State or local government (or political subdivision of a State 
or local government), or (2) July 2, 1986, in the case of an arrange- 
ment maintained by a tax-exempt organization. The grandfather 
treatment is limited to the employers who adopted the plan before 
the dates specified above. However, the grandfather treatment is 
not limited to employees (or classes of employees) covered by the 
plan as of the date the grandfather treatment is provided. Similar- 
ly, plans that are grandfathered may be amended in the future. 
Most such plans will, of course, have to be amended to take into 
account the new requirements relating to qualified cash or deferred 
arrangements. Other plan amendments may also be made. For ex- 
ample, a grandfathered plan may be amended in the future to pro- 
vide for employer matching contributions, to modify the level of 
employer matching contributions, or to provide that the qualified 
cash or deferred arrangement is part of a cafeteria plan. 



95 

Explanation of Provision 

The bill reconciles the statutory provision and the intent of Con- 
gress articulated in the Statement of Managers by providing that 
the prohibition on conditioning benefits on elective deferrals is not 
limited to employer-provided benefits. Thus, for example, a plan 
may not provide that voluntary after-tax employee contributions 
may not be made until an employee makes a specified amount of 
elective deferrals under a qualified cash or deferred arrangement. 

The bill modifies the grandfather rule applicable to section 401(k) 
plans maintained by governmental employers. Under the bill, the 
prohibition on section 401(k) plans does not apply to (1) an employ- 
er that is a State or local government (or political subdivision of a 
State or local government) if the employer adopted a section 401(k) 
plan before May 6, 1986, and (2) an employer that is a tax-exempt 
governmental unit other than a governmental unit described in (1) 
(e.g., the Tennessee Valley Authority), if the employer adopted a 
section 401(k) plan before July 2, 1986. Because the grandfather 
rule in the bill applies to the employer and not merely the plan, an 
employer that satisfies the conditions of the grandfather may adopt 
a new section 401(k) plan. 

Because the identity of the employer is more likely to change in 
the case of tax-exempt employers that are not governmental enti- 
ties (such as through a merger of unrelated tax-exempt organiza- 
tions), the bill limits this expansion of the grandfather rule to tax- 
exempt governmental units. 

3. Nondiscrimination requirements for employer matching contri- 
butions and employee contributions (sec. lll(m) of the bill, 
sec. 1117 of the Reform Act, and sees. 401(m) and 4979 of the 
Code) 

a. Special nondiscrimination test 

Present Law 

In general 

Under present law, a special nondiscrimination test is applied to 
employer matching contributions and employee contributions, in- 
cluding employee contributions under a qualified cost-of-living ar- 
rangement (sec. 415(k)). This special nondiscrimination test is simi- 
lar to the special nondiscrimination test applicable to qualified 
cash or deferred arrangements. 

The term "employer matching contributions" means any employ- 
er contribution made to the plan on behalf of an employee on ac- 
count of an employee contribution or an elective deferral under a 
qualified cash or deferred arrangement. Forfeitures under a plan 
that are reallocated to participants' accounts on the basis of em- 
ployee contributions or elective deferrals are, of course, also treated 
as matching contributions. 

Required aggregation 

If 2 or more plans of an employer to which matching contribu- 
tions, employee contributions, or elective deferrals are made are 
treated as a single plan for purposes of the coverage requirements 
for qualified plans (sec. 410(b)), then the plans are treated as a 



96 

single plan for purposes of the special nondiscrimination test. In 
addition, if a highly compensated employee participates in 2 or 
more plans of an employer to which matching contributions, em- 
ployee contributions, or elective deferrals are made, then all such 
contributions are aggregated for purposes of the special nondis- 
crimination test. 

Explanation of Provision 
In general 

Under the bill, the special nondiscrimination test applicable to 
matching contributions and employee contributions only applies to 
contributions to defined contribution plans within the meaning of 
sec. 414(k). Also under the bill, the definition of "matching contri- 
butions" includes any contribution to a defined contribution plan 
made on account of an employee contribution or an elective defer- 
ral under a qualified cash or deferred arrangement, whether such 
contributions are made to the same plan or a different plan. Con- 
tributions to a defined benefit pension plan may be employee con- 
tributions or matching contributions to the extent treated as con- 
tributions to a defined contribution plan (sec. 414(k)). The bill also 
clarifies, in accordance with the Statement of Managers, that con- 
tributions to a tax-sheltered annuity which are made on account of 
an employee contribution or elective deferral are employer match- 
ing contributions. 

Under the bill, employer matching contributions that are treated 
as elective deferrals for purposes of the special nondiscrimination 
test applicable to cash or deferred arrangements are not subject to 
the special test applicable to matching contributions and employee 
contributions. 

Required aggregation 

The bill modifies the requirement with respect to aggregation of 
plans in which a highly compensated employee participates. Under 
the bill, if a highly compensated employee participates in 2 or more 
plans of an employer to which contributions subject to the special 
nondiscrimination test (sec. 401(m)) are made, then all such contri- 
butions are aggregated for purposes of the test. For example, 
assume an employer maintains a plan with a cash or deferred ar- 
rangement under which matching contributions are made, and a 
thrift plan providing for after-tax employee contributions and 
matching contributions. Highly compensated employees participate 
in both plans. Under the bill, matching contributions that are not 
treated as elective deferrals in applying the special section 401(k) 
nondiscrimination test and after-tax contributions under the plans 
are aggregated for purposes of the special nondiscrimination test. 
The elective deferrals, however, are not required to be aggregated 
with the matching contributions and employee contributions. 

b. Treatment of excess aggregate contributions 
Present Law 

If the special nondiscrimination test is not satisfied for any year, 
the plan will not be disqualified if the excess aggregate contribu- 



97 

tions (plus income allocable to such contributions) are distributed 
before the close of the following plan year. Distribution of excess 
aggregate contributions by such date may be made notwithstanding 
any other provision of law, and the amount distributed is not sub- 
ject to the additional income tax on early withdrawals (sec. 72(t)). 
Contributions are not subject to the 10-percent tax on nondeduct- 
ible contributions (sec. 4972) merely because they are excess aggre- 
gate contributions. 

An excise tax is imposed on the employer with respect to excess 
contributions and excess aggregate contributions (sec. 4979). The 
tax is equal to 10 percent of the excess contributions and excess ag- 
gregate contributions (but not earnings on those contributions) 
under the plan for the plan year ending in the taxable year. 

However, the tax does not apply to any excess contributions or 
excess aggregate contributions that, together with income allocable 
to such contributions, are distributed (or, if nonvested, forfeited) no 
later than 2-1/2 months after the close of the plan year in which 
the contributions arose. 

Excess contributions (plus income), excess matching contributions 
(plus income), excess elective deferrals (plus income), excess quali- 
fied nonelective contributions (plus income), and income on excess 
employee contributions distributed within the applicable 2-1/2 
month period are to be treated as received and earned by the em- 
ployee in the employee's taxable year to which such contributions 
relate. Excess matching contributions are deemed to relate to the 
same taxable year to which the employee's mandatory contribution 
relates, i.e., mandatory contributions that are elective deferrals 
relate to the taxable year in which the employee would have re- 
ceived (but for the deferral election) the deferral as cash, and man- 
datory contributions that are employee contributions relate to the 
taxable year of contribution. For purposes of this rule, the first 
contributions (of the type distributed) for a plan year are deemed to 
be excess contributions or excess aggregate contributions. 

Explanation of Provision 

The bill provides that excess aggregate contributions for a plan 
year that are distributed before the end of the following plan year 
are not subject to the 15-percent excise tax on excess distributions 
(sec. 4980A). 

In .addition, to be consistent with the rules applicable to excess 
deferrals and excess contributions, the bill provides that such dis- 
tributions may be made without regard to the terms of the plan 
until the close of the first plan year for which an amendment is 
required (Act sec. 1140). The bill similarly provides that the Secre- 
tary is to prescribe a model amendment that allows a plan to dis- 
tribute excess aggregate contributions and that a plan distribution 
in accordance with such amendment is to be treated as in accord- 
ance with the terms of the plan. It is understood that the Secretary 
has already prescribed model amendments under the Act; accord- 
ingly, it is not intended that the Secretary be required to prescribe 
a new amendment regarding excess aggregate contributions. 

The Act provides that excess contributions and excess aggregate 
contributions that are distributed within 2-1/2 months after the 



98 

end of the plan year are treated as received and earned by the re- 
cipient in the taxable year to which the contribution relates in 
order to prevent deferral of income. Such deferral is not of major 
concern, however, where the amount involved is not significant. 
Accordingly, the Act provides an exception to the general rule. 
Under this exception, if the total distributions of excess contribu- 
tions and excess aggregate contributions under a plan for a plan 
year with respect to an individual are less than $100, then the dis- 
tributions are treated as earned and received by the individual in 
the taxable year in which the distributions were made. 

4. Unfunded deferred compensation arrangements of State and 
local governments and tax-exempt employers (sec. 111(e) of 
the bill, sec. 1107 of the Reform Act, and sec. 457 of the Code) 

a. Application to tax-exempt employers; distribution re- 

quirements 

Present Law 

The Act applies the limitations and restrictions applicable to eli- 
gible and ineligible unfunded deferred compensation plans of State 
and local governments (sec. 457) to unfunded deferred compensa- 
tion plans maintained by nongovernmental tax-exempt organiza- 
tions. 

Under the Act, distributions cannot be made available to partici- 
pants or beneficiaries under a section 457 plan before the partici- 
pant is separated from service with the employer or is faced with 
an unforeseeable emergency. In addition, distributions under a sec- 
tion 457 plan are required to comply with the provisions of section 
401(a)(9). Under section 401(a)(9) as amended by the Act, distribu- 
tions must begin no later than the April 1 of the calendar year fol- 
lowing the calendar year the participant attains age 70 Va, regard- 
less of whether the participant is still employed. Thus, section 
401(a)(9) may require that distribution is to begin before the time 
that distributions are permitted under section 457. 

Explanation of Provision 

The bill reconciles the rules under section 457 and section 
401(a)(9) relating to the time that distributions are to be made. 
With respect to the rule prohibiting distributions prior to separa- 
tion from service or the occurrence of an unforeseen emergency, 
the bill provides an exception for distributions in or after the year 
in which the employee attains age 70 ¥2. Thus, under the bill, 
amounts may not be available under a section 457 plan earlier 
than (1) the calendar year in which the participant attains age 
70 y2, (2) when the participant separates from service, or (3) when 
the participant is faced with an unforeseeable emergency. 

b. Amount of deferrals 

Present Law 

Under present law, an unfunded deferred compensation plan is 
not an eligible plan if it permits deferred compensation in excess of 
the limits contained in section 457. The limit on deferred compen- 



99 

sation under a section 457 plan is coordinated with contributions to 
a tax-sheltered annuity (sec. 403(b)). In addition, under the Act, the 
limit under section 457 is coordinated with elective deferrals under 
a cash or deferred arrangement, a simplified employee pension, or 
a plan described in section 501(c)(18). 

Explanation of Provision 

An employee may participate in a section 457 plan of 1 employer 
and, for example, a cash or deferred arrangement of another em- 
ployer. Thus, the employer maintaining the section 457 plan may 
not know whether an employee is making elective deferrals to a 
plan that is coordinated with the section 457 plan for purposes of 
the limit on deferred compensation. Thus, it is not appropriate to 
disqualify the entire section 457 plan in such cases. 

Accordingly, the bill provides that, for purposes of determining 
whether an unfunded deferred compensation plan is an eligible 
plan under section 457, the rule requiring coordination of the de- 
ferred compensation limit with other plans is disregarded. Of 
course, if the limit (as so coordinated) is exceeded, the deferral of 
income inclusion provided by section 457 does not apply to the 
excess; instead, the rules of section 457(f) apply to such excess. 

In order to prevent avoidance of the limit on deferred compensa- 
tion under a section 457 plan by, for example, the use of affiliated 
service groups or leasing arrangements, the bill provides that the 
Secretary's general regulatory authority to prevent avoidance of 
certain requirements (sec. 414(o)) applies to section 457 plans. 

c. Effective date 

Present Law 

Under the Act, the requirements of section 457 do not apply to 
amounts deferred under a plan established by a nongovernmental 
tax-exempt employer with respect to an employee that (1) were de- 
ferred for taxable years beginning before January 1, 1987, or (2) are 
deferred for taxable years beginning after December 31, 1986, pur- 
suant to an agreement between the employer and the employee 
that (a) was in writing on August 16, 1986, and (b) on August 16, 
1986, provided for a deferral for each taxable year of a fixed 
amount or an amount determined pursuant to a fixed formula. 
This exception does not apply with respect to amounts deferred in 
a fixed amount or under a fixed formula (including a fixed formula 
under a plan that is in the nature of a defined benefit plan) for any 
taxable year ending after the date on which the amount or formula 
is modified after August 16, 1986. The Act was unclear as to wheth- 
er a plan is required to satisfy the requirements of section 457 (i.e., 
be an eligible plan) in order to qualify for the grandfather. 

Explanation of Provision 

The bill clarifies that the grandfather rule applicable to unfund- 
ed deferred compensation arrangements of tax-exempt employers 
applies to all deferred compensation plans of tax-exempt employers 
that otherwise meet the requirements of the grandfather rule. 



100 

without regard to whether the plans would be eligible deferred 
compensation plans within the meaning of section 457. 

The bill also clarifies that the grandfather rule only applies to 
individuals who were covered under the plan and agreement on 
August 16, 1986. Thus, for example, the grandfather does not apply 
to a new employee hired after August 16, 1986, or an employee who 
was hired on or before such date, but who was not a participant in 
the deferred compensation plan until after August 16, 1986. 

5. Deferred annuity contracts (sec. lllA(i) of the bill, sec. 1135 of 
the Reform Act, and sec. 72(u) of the Code) 

Present Law 

Under the Act, if any annuity contract is held by a person who is 
not a natural person (such as a corporation or trust), then the con- 
tract is not treated as an annuity contract for Federal income tax 
purposes and the income on the contract for any taxable year is 
treated as ordinary income received or accrued by the owner of the 
contract during the taxable year. In the case of a contract the 
nominal owner of which is a person who is not a natural person, 
but the beneficial owner of which is a natural person, the contract 
is treated as held by a natural person. 

The provision does not apply to any annuity contract that (1) is 
acquired by the estate of a decedent by reason of the death of the 
decedent; (2) is held under a qualified plan (sec. 401(a) or 403(a)), as 
a tax-sheltered annuity (sec. 403(b)) or under an IRA; (3) is a quali- 
fied funding asset for purposes of a structured settlement agree- 
ment (as defined in sec. 130(d), but without regard to whether there 
is a qualified assignment); (4) is purchased by an employer upon 
the termination of a qualified plan and is held by the employer 
until the employee separates from service; or (5) is an immediate 
annuity. 

Explanation of Provision 

The rule under which certain contracts will not be treated as an- 
nuity contracts was intended to apply for purposes of the Federal 
income taxation of the policyholder, but was not intended to extend 
to the tax treatment of the insurance company. Accordingly, the 
bill would clarify that the treatment of annuity contracts held by 
nonnatural persons applies generally for purposes of subtitle A of 
Title I of the Code, other than subchapter L. 

The bill also provides that, with respect to the exception to the 
rule regarding treatment of annuity contracts held by nonnatural 
persons for an annuity that is purchased by an employer upon ter- 
mination of a qualified plan, the exception applies to an annuity 
that is held until all amounts are distributed to the employee for 
whom such contract was purchased or to the employee's benefici- 
ary. 



101 

6. Elective contributions under tax-sheltered annuities (sec. 111(c) 
of the bill, sec. 1105 of the Reform Act, and sec. 402 of the 
Code) 

Present Law ^^ 

The Act imposes a limit on elective deferrals under a tax-shel- 
tered annuity that operates in the same manner as the limit on 
elective deferrals under a qualified cash or deferred arrangement. 
However, the annual limit on elective deferrals under a tax-shel- 
tered annuity is $9,500 rather than $7,000. The $9,500 limit applies 
until the cost-of-living adjustments to the annual limit on elective 
deferrals under a qualified cash or deferred arrangement raise that 
limit from $7,000 to $9,500, at which time the limit on elective de- 
ferrals under a tax-sheltered annuity is also indexed at the same 
time and in the same manner as the indexing of the annual limit 
for elective deferrals under a qualified cash or deferred arrange- 
ment. 

The Act provides an exception to the $9,500 annual limit (but not 
to the otherwise applicable exclusion allowance (sec. 403(b)) or the 
limit on contributions and benefits (sec. 415)) in the case of employ- 
ees of an educational organization, a hospital, a home health serv- 
ice agency, a health and welfare service agency, a church, or a con- 
vention or association of churches. Under this exception, any eligi- 
ble employee who had completed 15 years of service with the em- 
ployer would be permitted to make an additional salary reduction 
contribution under the following conditions: 

(1) In no year can the additional contributions be more than 
$3,000 (and, therefore, the $9,500 limit may not be increased above 
$12,500); 

(2) An aggregate limit of $15,000 applies to the total amount of 
catch-up contributions (i.e., contributions that, in any year, exceed 
the limit on elective deferrals for that year); and 

(3) In no event can this exception be used if an individual's life- 
time elective deferrals exceed the individual's lifetime limit. 

The lifetime limit on elective deferrals for an individual, solely 
for purposes of the special catch-up rule, is $5,000 multiplied by the 
number of years of service that the individual performed with the 
employer. 

It is intended that the definition of years of service for purposes 
of the special catchup election will include principles similar to the 
principles of section 414(a). For this purpose, an employee's years of 
service will be determined by including all years of service with a 
predecessor employer (within the meaning of sec. 414(a)). Thus, 
years of service with a denomination of a church that merges into 
or combines with another denomination generally are to be aggre- 
gated with years of service with the surviving denomination. 

Explanation of Provision 

The Act does not specify how years of service are to be deter- 
mined for purposes of the catch-up rule. The bill provides that, for 
this purpose, years of service are defined as in section 403(b). This 
definition will provide consistency with the way years of service 



102 

are generally calculated under the rules relating to tax-sheltered 
annuities. 

It is recognized that it may be difficult for employers to calculate 
the lifetime limit on elective deferrals for purposes of the catch-up 
rule because employers may not have records for prior years with 
respect to the portion of contributions to tax-sheltered annuities 
that were elective deferrals. Accordingly, under the bill, for pur- 
poses of calculating the lifetime limit under the catch-up rule, elec- 
tive deferrals for prior years are to be determined in the manner 
prescribed by the Secretary. Under this provision, it is expected 
that the Secretary will provide administrable methods that employ- 
ers can use to calculate elective deferrals for prior years. 

7. Special rules for simplined employee pensions (sec. 111(f) of 
the bill, sec. 1108 of the Reform Act, and sec. 408(k) of the 
Code) 

a. Salary reduction SEPs 

Present Law 

Under the Act, employees who participate in a SEP are permit- 
ted to elect to have contributions made to the SEP or to receive the 
contributions in cash. If an employee elects to have contributions 
made on the employee's behalf to the SEP, the contribution is not 
treated as having been distributed or made available to the em- 
ployee. In addition, the contribution is not treated as an employee 
contribution merely because the SEP provides the employee with 
such an election. Therefore, under the Act, an employee is not re- 
quired to include in income currently the amounts the employee 
elects to have contributed to the SEP. Elective deferrals under a 
SEP are to be treated in the same manner as elective deferrals 
under a qualified cash or deferred arrangement and, thus, are sub- 
ject to the $7,000 (indexed) cap on elective deferrals. 

The Act provides that the tax treatment described above of the 
election to have amounts contributed to a SEP or received in cash 
is available only if at least 50 percent of the employees of the em- 
ployer elect to have amounts contributed to the SEP. In addition, 
this exception to the constructive receipt principle is available for a 
taxable year only if the employer maintaining the SEP had 25 or 
fewer employees at all times during the prior taxable year. 

In addition, under the Act, the amount eligible to be deferred as 
a percentage of each highly compensated employee's compensation 
(i.e., the deferral percentage) is limited by the average deferral per- 
centage (based solely on elective deferrals) for all nonhighly com- 
pensated employees who are eligible to participate. The deferral 
percentage for each highly compensated employee cannot exceed 
125 percent of the average deferral percentage for all eligible non- 
highly compensated employees. 

If the 125-percent test is not satisfied, rules similar to the rules 
applicable to excess contributions to a cash or deferred arrange- 
ment are to apply. 



103 

Explanation of Provision 

The bill clarifies that, for purposes of the rules relating to SEPs 
(other than sec. 408(k)(2)(C)), the uniform definition of compensa- 
tion (sec. 414(s)) applies. The bill also clarifies that, for purposes of 
applying the 125-percent test to a salary reduction SEP, compensa- 
tion does not include compensation in excess of $200,000. 

The bill clarifies that, in determining whether the employer 
maintaining a salary reduction SEP had more than 25 employees 
in the prior taxable year, employees who were eligible to partici- 
pate in the SEP (or would have been required to be eligible to par- 
ticipate if a SEP were maintained) are taken into account. This 
rule provides consistency with the eligibility rules for SEPs, that is, 
individuals who are not required to be eligible to participate in the 
SEP may be disregarded in determining whether the 25-employee 
rule is satisfied. 

The bill adds provisions designed to ensure that excess contribu- 
tions to a salary reduction SEP are distributed. These rules are 
somewhat different from the rules relating to excess deferrals in 
cash or deferred arrangements because, in the case of a SEP, the 
employer may not force an employee to take a distribution of 
excess deferrals because the SEP contributions are held in an IRA 
which the employee controls. 

The bill specifically authorizes the Secretary to prescribe appro- 
priate rules, including rules requiring that the excess contributions 
(plus income) be distributed, reporting requirements, and rules pro- 
viding that contributions to a SEP (plus income) may not be with- 
drawn until a determination that the special nondiscrimination 
test has been satisfied is made. In addition, the bill provides that, 
until such a determination has been made, any transfer or distribu- 
tion from a SEP of salary reduction contributions (or income on 
such contributions) is subject to tax in accordance with section 72 
and to the early withdrawal tax (sec. 72(t)(l)), regardless of whether 
an exception to the tax would otherwise be available. 

Consistent with the inclusion of SEP contributions that are made 
pursuant to a salary reduction agreement for purposes of PICA 
(sec. 3121(a)(5)) and FUTA (sec. 3306(b)(5)), the bill would include 
such contributions for purposes of determining benefits under the 
Social Security Act. 

b. Integration rules 

Present Law 

The Act eliminated the prior-law rules under which nonelective 
SEP contributions could be combined with employer OASDI contri- 
butions for purposes of the applicable nondiscrimination require- 
ments. In place of these rules, the Act permits nonelective SEP 
contributions to be tested for nondiscrimination under the new 
rules for qualified defined contribution plans permitting a limited 
disparity between the contribution percentages applicable to com- 
pensation below and compensation above the integration level. This 
provision is effective for years beginning after December 31, 1986. 
The new rules for defined contribution plans permitting a limited 



104 

disparity between contribution levels are generally applicable to 
qualified plans for years beginning after December 31, 1988. 

Explanation of Provision 

The bill coordinates the effective date of the new integration 
rules with respect to qualified plans and SEPs. Thus, the bill pro- 
vides that the integration rules applicable to SEPs (sec. 408(k)(3)(D) 
and (E)) prior to the Act will continue to apply to years beginning 
before January 1, 1989, when the new integration rules are effec- 
tive. However, no integration is permitted under the 125-percent 
test. 

c. Income exclusion 

Present Law 

Under present law, contributions to SEPs are excludable from 
income, rather than allowable as a deduction as under prior law. 

Explanation of Provision 

To conform to the conversion of the SEP deduction to an exclu- 
sion, the bill provides that, for purposes of section 408(d)(4), (5) and 
section 4973, an amount excludable from income under section 
402(h) is treated as an amount allowable as a deduction under sec- 
tion 219. 

d. Employer deduction 

Present Law 

Employer contributions to a SEP are deductible (1) in the case of 
a calendar year SEP, for the taxable year with or within which the 
calendar year ends, and (2) in the case of a SEP maintained on the 
basis of the taxable year of the employer, for such taxable year. 
The amount deductible in a taxable year for contributions to a SEP 
may not exceed 15 percent of the compensation paid to the employ- 
ees during the calendar year ending with or within the taxable 
year. 

Explanation of Provision 

To take into account SEPs that are maintained on the basis of 
the employer's taxable year, the bill provides that, in the case of 
such SEPs, the 15 percent of compensation limitation applies to 
compensation paid during the employer's taxable year. 



B. Nondiscrimination Requirements 

1. Minimum coverage requirements (sec. 111(h) of the bill, sec. 

1112 of the Reform Act, and sec. 410(b) of the Code) 

Present Law 

Under present law, a plan is not qualified unless it meets at least 
one of the following coverage requirements: 

(1) the plan benefits at least 70 percent of all nonhighly compen- 
sated employees; 

(2) the plan benefits a percentage of nonhighly compensated em- 
ployees that is at least 70 percent of the percentage of highly com- 
pensated employees benefiting under the plan; or 

(3) the plan meets the average benefits test, one requirement of 
which is that the average benefit percentage for nonhighly compen- 
sated employees be at least 70 percent of the average benefit per- 
centage for highly compensated employees. 

Explanation of Provision 

The bill incorporates in the statute the provision in the State- 
ment of Managers that a plan maintained by an employer that has 
no nonhighly compensated employees for a year is considered to 
satisfy the coverage requirements for such year. As is so with re- 
spect to the coverage rules generally, this rule is to apply separate- 
ly with respect to former employees under rules prescribed by the 
Secretary. 

2. Minimum participation rule (sec. 111(h) of the bill, sec. 1112 of 

the Reform Act, and sec. 401(a)(26) of the Code) 

Present Law 
In general 

Under present law, a plan is not a qualified plan unless it bene- 
fits no fewer than the lesser of (a) 50 employees of the employer, or 
(b) 40 percent of all employees of the employer. This requirement 
may not be satisfied by aggregating comparable plans. Also, this re- 
quirement applies on an employer-wide basis and may not be satis- 
fied on a line of business or operating unit basis. 

Sanction 

If a plan ceases to be qualified because of this minimum partici- 
pation rule, it is subject to the generally applicable sanctions, one 
of which is that employer contributions made to the trust during 
the corresponding taxable year of the employer are includible in 
employees' incomes under rules applicable to nonqualified arrange- 
ments (sec. 83). Under present law, in the case of a plan that fails 

(105) 



106 

to be qualified solely because it does not satisfy the coverage re- 
quirements (sec. 410(b)), the employee's vested accrued benefit 
(other than employee contributions), to the extent that such 
amount has not been previously taxed to the employee, is includ- 
ible in income, rather than the employer's contribution for the 
year. Also, nonhighly compensated employees are not taxable on 
amounts contributed to or earned by the trust merely because a 
plan fails to satisfy the coverage requirements. 

Special transition rule 

For purposes of the coverage rules, but not the minimum partici- 
pation rule, a special transition rule applies in the case of certain 
dispositions or acquisitions of a business (sec. 410(b)(6)(C)). 

Reversion tax and interest rate 

The minimum participation rule is generally effective for plan 
years beginning after December 31, 1988. 

Under a special rule, if (1) a plan is in existence on August 16, 
1986, (2) the plan would fail to meet the requirements of the mini- 
mum participation rule if such rule were in effect on August 16, 
1986, and (3) there is no transfer of assets to or liabilities from the 
plan, or merger or spinoff involving the plan, after August 16, 
1986, that has the effect of increasing the amount of assets avail- 
able for an employer reversion, such plan may be terminated or 
merged prior to the first plan year to which the minimum partici- 
pation rule applies and the 10-percent excise tax on the reversion 
of assets (sec. 4980) will not be imposed on any employer reversion 
from such plan by reason of such termination or merger. Such a 
termination and reversion are permissible even though the termi- 
nating plan relies on another plan that is not terminated for quali- 
fication. In determining the amount of any such employer rever- 
sion, the present value of the accrued benefit of any highly com- 
pensated employee is to be determined by using an interest rate 
that is equal to the maximum interest rate that may be used for 
purposes of calculating a participant's accrued benefit under sec- 
tion 411(a)(ll)(B). The Secretary is to prescribe rules preventing 
avoidance of this interest rate rule through distributions prior to or 
in lieu of a reversion. 

Explanation of Provision 
Sanction 

The bill modifies the sanction applicable to a plan that ceases to 
be qualified based on a failure to satisfy either the minimum par- 
ticipation rule or the coverage rules. Under the bill, if a plan is not 
qualified and one of the reasons is the failure to satisfy the mini- 
mum participation rule or the coverage rules, any highly compen- 
sated employee is to include in income such employee's vested ac- 
crued benefit (other than such employee's investment in the con- 
tract). (This modification does not affect the application of the gen- 
eral rules of sec. 402(b)(1) regarding issues other than the amount 
includible in the year of disqualification, such as the application of 
sec. 72 to distributions from the disqualified plan.) 



107 

In addition, if a plan is not qualified solely because it does not 
satisfy either the minimum participation rule or the coverage rule 
or both, the bill provides that there is to be no inclusion in income 
by reason of such failure to qualify with respect to any employee 
who was not a highly compensated employee at any time during 
the trust year in which the plan became disqualified or during any 
prior year for which service was creditable to such employee under 
the plan (or a predecessor plan). For purposes of determining 
whether an employee was a highly compensated employee in any 
year, the definition of highly compensated employee applicable 
with respect to such year for purposes of the coverage rules is to 
apply. 

Except for these changes, the sanctions applicable under present 
law, including the rules regarding the disallowance of an employ- 
er's deduction for contributions to a disqualified plan, continue to 
apply. 

These modifications of the sanctions for disqualification are in- 
tended to fulfill the intent of the Act with respect to (1) ensuring 
that the disqualification sanction is adequate with respect to highly 
compensated employees, and (2) reducing the sanction with respect 
to nonhighly compensated employees in appropriate circumstances. 

Applicability of affiliated service group and employee leasing rules 

In order to prevent avoidance of the minimum participation rule, 
the bill provides that the affiliated service group rules (sec. 414(m)) 
and the employee leasing rules (sec. 414(n)) apply for purposes of 
the minimum participation rule. The bill further clarifies that the 
Secretary's general regulatory authority to prevent avoidance of 
certain requirements (sec. 414(o)) applies to the minimum participa- 
tion rule. 

Special transition rule 

Under the bill, the special transition rule applicable in the case 
of certain dispositions or acquisitions of a business (sec. 410(b)(6)(C)) 
is to apply to the minimum participation rule. This is intended to 
prevent the minimum participation rule from disrupting business 
transactions by allowing a grace period following certain transac- 
tions for the new entities to comply with the minimum participa- 
tion rule. 

Reversion tax and interest rate 

With respect to the rule under present law regarding the exemp- 
tion from the reversion tax in the case of the termination or 
merger of certain plans not satisfying the minimum participation 
rule, the interest rate required to be used in determining the ac- 
crued benefit of any highly compensated employee and the corre- 
sponding reversion to the employer will in many cases understate 
the value of the employee's accrued benefit and thus represent a 
cutback in the employee's accrued benefit. In order to avoid this 
result, the bill modifies the rule referred to above in several re- 
spects. 

First, the bill clarifies that for purposes of determining the 
amount to be distributed from a plan to an employee, the value of 
an employee's accrued benefit is not to be affected by this transi- 



108 

tional rule regarding the minimum participation rule. Thus, for 
this purpose, the accrued benefit is to be determined under the in- 
terest rate used by the plan, if otherwise permissible under the 
Code. 

Second, the bill provides a rule regarding the permissible inter- 
est rate to be used for certain purposes. The interest rate rule ap- 
plies in the case of the termination or merger of a plan that (1) was 
in existence on August 16, 1986, and (2) would have failed to satisfy 
the requirements of the minimum participation rule had such rule 
been in effect on August 16, 1986. For this purpose, the term "ter- 
mination or merger" is intended to include any similar transaction, 
such as a consolidation. 

If the interest rate rule applies to a plan, the interest rate used 
in determining an "eligible amount" is to be no less than the high- 
est of: 

(1) the rate in effect under the plan on August 16, 1986, or if on 
August 16, 1986, the rate is determined under a formula (or other 
method), the rate determined under such formula (or other 
method); 

(2) the highest rate used under the plan at any time after August 
15, 1986, and before the termination or merger in calculating the 
present value of the accrued benefit of a nonhighly compensated 
employee under the plan (or any other plan used in determining 
whether the plan meets the requirements of sec. 401); or 

(3) 5 percent. 

For purposes of (1) above, the rate is to be determined without 
regard to any amendment adopted after August 16, 1986, even if 
such amendment is effective retroactively to apply on August 16, 
1986. 

The term "eligible amount" means the amount of any distribu- 
tion with respect to a highly compensated employee that: 

(1) may be rolled over under the applicable rules (sec. 402(a)(5)); 

(2) is eligible for income averaging (sec. 402(e)(1)) or grandfa- 
thered capital gains treatment; or 

(3) may be transferred to another plan without inclusion in 
income. 

In addition, if an annuity contract purchased after August 16, 
1986, is distriijuted to a highly compensated employee by a plan to 
which the interest rate rule applies in connection with the termi- 
nation or merger of such plan, the annuity contract is included in 
the employee's income to the extent of the excess of the purchase 
price of such contract over the present value of such contract using 
the lowest interest rate permitted in determining an eligible 
amount under the rules described above. However, such excess is to 
be disregarded for purposes of the early withdrawal tax (sec. 72(t)) 
and the excess distribution tax (sec. 4980A). 

In the case of the termination or merger of a plan to which the 
interest rate rule applies, the excess (if any) of (1) the amount dis- 
tributed to a highly compensated employee by reason of the termi- 
nation or merger, over (2) the amount determined by using the 
lowest interest rate permitted in determining an eligible amount, 
also is disregarded for purposes of the early withdrawal tax and 
the excess distribution tax. 



109 

3. Vesting standards (sec. lll(i) of the bill and sec. 1113 of the 
Reform Act) 

Present Law — ^ 

Under present law, a plan (other than a multiemployer plan) is 
not qualified unless a participant's employer-provided benefit vests 
at least as rapidly as under 1 of 2 alternative schedules. A plan sat- 
isfies the first schedule if a participant has a nonforfeitable right to 
100 percent of the participant's accrued benefit derived from em- 
ployer contributions upon completion of 5 years of service. A plan 
satisfies the second schedule if a participant has a nonforfeitable 
right to at least 20 percent of the participant's accrued benefit de- 
rived from employer contributions after 3 years of service, 40 per- 
cent at the end of 4 years of service, 60 percent at the end of 5 
years of service, 80 percent at the end of 6 years of service, and 100 
percent at the end of 7 years of service. 

In the case of a multiemployer plan, a participant's accrued ben- 
efit derived from employer contributions is required to be 100-per- 
cent vested no later than upon the participant's completion of 10 
years of service. This exception applies only to employees covered 
by the plan pursuant to a collective bargaining agreement. 

Prior to the Act, special vesting rules applied to class-year plans. 
A class-year plan was a profit-sharing, money purchase, or stock 
bonus plan that provided for the separate vesting of employee 
rights to employer contributions on a year-by-year basis. The mini- 
mum vesting requirements were satisfied under prior law if the 
plan provided that a participant's rights to amounts derived from 
employer contributions with respect to any plan year were nonfor- 
feitable not later than the close of the fifth plan year following the 
plan year for which the contribution was made. 

The imposition of the new vesting rules described above, includ- 
ing the repeal of class-year vesting, generally apply to plan years 
beginning after December 31, 1988, with respect to participants 
who have at least 1 hour of service after the effective date. 

Explanation of Provision 

The repeal of class-year vesting was not intended to adversely 
affect the vesting status of any participant. To fulfill this intent, 
the bill provides a special rule applicable to plans that after Octo- 
ber 22, 1986, used class-year vesting. Whether a plan falls within 
this category is to be determined without regard to any amend- 
ment adopted after October 22, 1986, eliminating class-year vesting. 

Plans that fall within the above category are to apply a special 
rule to any employee that has an hour of service (1) before the 
adoption of any amendment eliminating class-year vesting, and (2) 
on or after the first day of the first plan year for which the repeal 
of class-year vesting is applicable to such employee with respect to 
the plan. Under this special rule, for the year described in (2) above 
and any subsequent year, the employee's nonforfeitable right to the 
employee's accrued benefit derived from employer contributions is 
to be determined under the class-year vesting schedule that was 
eliminated if such schedule would yield a larger nonforeitable right 
than the new vesting schedule. 



110 

4. Application of nondiscrimination rules to integrated plans (sec. 
111(g) of the bill, sec. 1111 of the Reform Act, and sees. 
401(a)(5) and (1) of the Code) 

Present Law 

Under present law, a plan is not considered discriminatory 
merely because contributions or benefits of, or on behalf of, the em- 
ployees under the plan favor highly compensated employees 
through permissible integration of the plan. In general, in the case 
of a defined contribution plan, whether integration is permissible is 
determined by comparing contributions with respect to compensa- 
tion above the integration level with contributions with respect to 
compensation up to the integration level. In the case of a defined 
benefit excess plan, the rules apply to benefits, rather than contri- 
butions, with respect to compensation above and below the integra- 
tion level. 

In the case of a defined benefit excess plan, certain special tests 
apply if the integration level is above covered compensation. For 
this purpose, the term "covered compensation" means, with respect 
to an employee, the average of the taxable wage bases in effect for 
each year during the 35-year period ending with the year the em- 
ployee attains age 65, assuming no increase in such wage base for 
years after the current year and before the employee actually at- 
tains age 65. 

An integrated defined benefit plan is required to base benefits on 
average annual compensation. 

Explanation of Provision 

The bill clarifies that generally it is only employer-provided con- 
tributions and benefits that are taken into account in determining 
whether the contributions or benefits with respect to compensation 
above and below the integration level satisfy the integration rules. 

To fulfill Congressional intent to conform certain qualified plan 
rules to the social security system, the bill modifies the definition 
of "covered compensation," so that the references to age 65 are re- 
placed by social security retirement age (sec. 415(b)(8)), which can 
be between age 65 and age 67, depending on the date of birth of the 
employee. 

The bill also clarifies that "average annual compensation" 
means the participant's highest average annual compensation for 
any period of at least 3 consecutive years (or, if shorter, the partici- 
pant's full period of service). Thus, defined benefit plans providing 
benefits based on career average compensation are not prevented 
from integrating. 



Ill 

5. Definitions of highly compensated employee and of line of busi- 
ness (sec. lil(j) and (k) of the bill, sees. 1114 and 1115 of the 
Reform Act, and sec. 414(q) and (r) of the Code) 

Present Law 
Highly compensated employee 

In general 

In general, under present law, an employee, including a self-em- 
ployed individual, is treated as highly compensated with respect to 
a year if, at any time during the year or the preceding year, the 
employee (1) was a 5-percent ow^ner of the employer (as defined in 
sec. 416(i)); (2) received more than $75,000 in annual compensation 
from the employer; (3) received more than $50,000 in annual com- 
pensation from the employer and was a member of the top-paid 
group (generally, the top 20 percent by compensation) during the 
same year, or (4) was an officer of the employer (generally, as de- 
fined in sec. 416(i)). 

Treatment of family members 

Present law provides a special rule for the treatment of family 
members of certain highly compensated employees. Under the spe- 
cial rule, if an employee is a family member of either a 5-percent 
owner or 1 of the top 10 highly compensated employees by compen- 
sation, then any compensation paid to such family member and 
any contributions or benefits under the plan on behalf of such 
family member are aggregated with the compensation paid and 
contributions or benefits on behalf of the 5-percent owner or the 
highly compensated employee in the top 10 employees by compen- 
sation. Therefore, such family member and employee are treated as 
a single highly compensated employee. 

An individual is considered a family member if, with respect to 
an employee, the individual is a spouse, lineal ascendant or de- 
scendant, or spouse of a lineal ascendant or descendant of the em- 
ployee. 

Even if a family member is excluded for purposes of determining 
the number of employees in the top-paid group (as discussed below), 
such family member is subject to the aggregation rule. 

Top-paid group 

The top-paid group of employees includes all employees who are 
in the top 20 percent of the employer's workforce on the basis of 
compensation paid during the year. For purposes of deterrnining 
the size of the top-paid group (but not for identifying the particular 
employees in the top-paid group), the following employees may be 
excluded: (1) employees who have not completed 6 months of serv- 
ice; (2) employees who normally work less than 11^2. hours per 
week; (3) employees who normally work not more than 6 months 
during any year; (4) except to the extent provided in regulations, 
employees who are included in a unit of employees covered by a 
collective bargaining agreement; (5) employees who have not at- 
tained age 21; and (6) employees who are nonresident aliens and 
who receive no United States-source earned income. An example of 



112 

an instance in which it is appropriate to consider employees cov- 
ered by a collective bargaining agreement is the case in which the 
plan being tested is maintained pursuant to a collective bargaining 
agreement. 

For purposes of this special rule, an employer may elect to apply 
numbers (1), (2), (3), and (5) above by substituting any shorter 
period of service or lower age than is specified in (1), (2), (3), or (5), 
as long as the employer applies the test uniformly for purposes of 
determining its top-paid group with respect to all its qualified 
plans and employee benefit plans and for purposes of the line of 
business or operating unit rules described below. 

Line of business or operating unit rules 

Generally, if an employer is treated as operating separate lines 
of business or operating units for a year, the employer may apply 
the new coverage rules applicable to qualified plans and the new 
nondiscrimination rules applicable to statutory employee benefit 
plans separately to each separate line of business or operating unit 
for that year. 

Under a special rule, a line of business or operating unit will not 
be treated as separate unless it satisfies certain requirements, one 
of which is that the line of business or operating unit have at least 
50 employees. 

Explanation of Provision 
Highly compensated employees 

Indexing 

The bill provides that the $50,000 and $75,000 amounts are to be 
adjusted at the same time and in the same manner as the dollar 
limit applicable to defined benefit plans (sec. 415(d)). Such adjust- 
ments will prevent the definition of "highly compensated employ- 
ee" from becoming inappropriate by virtue of inflation. 

Nonresident aliens 

In addition, under the bill, nonresident aliens who receive no 
United States-source earned income from the employer are to be 
disregarded for all purposes in determining the identity of the 
highly compensated employees of the employer. This modification 
will simplify the application of the rules and will prevent employ- 
ees who are disregarded for purposes of the nondiscrimination 
rules from affecting the identity of the highly compensated employ- 
ees. 

Treatment of family members 

The bill clarifies the applicability of the special rule for family 
members of certain highly compensated employees. The rule gener- 
ally is to be used in applying any provision that refers to the defi- 
nition of highly compensated employee (e.g., sees. 89, 401(a)(4), 
401(a)(5), 401(k), 401(1) (through sec. 401(a)(5)), 401(m), 403(b)(12) (by 
reference to 401(a)(4), etc.), 408(k), 410(b)). Thus, the special rule 
does not apply for purposes of, for example, the limits on contribu- 
tions or benefits (sec. 415) or the $7,000 limit on elective deferrals 



113 

(sec. 402(g)). In addition, the bill provides the Secretary with regu- 
latory authority to prevent the application of the special family 
member rule to inappropriate, clearly unintended situations. This 
regulatory authority is only to be used, however, in a manner con- 
sistent with the general policy underlying the family member rule, 
i.e., that, for purposes of all rules relating to nondiscrimination (or 
deductibility), the members of the family constitute one economic 
unit and thus are to be treated as one employee. 

The bill also clarifies that the special family member rule applies 
for purposes of the $200,000 limit on the amount of compensation 
that may be taken into account under a qualified plan (for qualifi- 
cation or deduction purposes) or under an employee benefit plan 
(sees. 89, 401(a)(17), and 404(1)). However, for this purpose, the defi- 
nition of a family member is modified to refer only to the employ- 
ee's spouse and children of the employee who do not attain age 19 
by the close of the year. 

For example, assume that employee A of employer X receives 
compensation (as defined under sec. 414(s)) of $275,000 and is the 
highly compensated employee with the highest compensation from 
X. A's spouse (B), adult child (C), and 17-year old child (D) also are 
employees of X. B, C, and D receive $100,000, $225,000, and $10,000 
of compensation (as defined under sec. 414(s)), respectively. X main- 
tains a qualified cash or deferred arrangement (sec. 401(k)) under 
which A, B, C, and D are eligible. A, B, and C each defers $7,000 
under the arrangement; D makes no deferral. 

For purposes of applying the special nondiscrimination test appli- 
cable to the arrangement (sec. 401(k)(3)), A, B, C, and D are treated 
as 1 employee. The compensation of this "1 aggregated employee" 
is determined as follows: A, B, and D are combined and limited to 
$200,000 (rather than the $385,000 they actually receive). The 
$200,000 limit applies separately to C because, under the special 
definition of a family member for purposes of the $200,000 limit, C 
is not a family member of A, B, or D. Thus, the compensation 
taken into account for the aggregated employee is $200,000 (for A, 
B, and D) plus $200,000 (for C) for a total of $400,000. The total de- 
ferrals for this aggregated employee are $21,000. Thus, for purposes 
of applying the special nondiscrimination test to the cash or de- 
ferred arrangement. A, B, C, and D are treated as a single employ- 
ee with a deferral percentage of $21,000/$400,000 or 5.25 percent. 
Since the family aggregation rule does not apply for purposes of 
the $7,000 limit on elective deferrals (sec. 402(g)), none of the 
family members is considered to have exceeded such limit. 

The bill further clarifies the application of the special family 
member rule to the integration rules under section 401(1). Al- 
though the special family member rule generally applies for pur- 
poses of section 401(1), it does not apply in determining the amount 
of compensation below the plan's integration level except that the 
total of the compensation below the integration level is subject to 
the $200,000 limit (sec. 401(a)(17)). Thus, for example, assume the 
same facts described in the above example, except that instead of 
maintaining a qualified cash or deferred arrangement, X maintains 
an integrated, nonelective profit-sharing plan with an integration 
level of $43,800. Again, the compensation of the aggregated employ- 
ee is $400,000. Of that $400,000, a total of $141,400 is considered to 



73-917 0-87-5 



114 

be below the integration level (i.e., $43,800 each attributable to A, 
B, and C, and $10,000 attributable to D). 

Line of business or operating unit rules 

Under the bill, the Secretary is to prescribe rules providing cer- 
tain minimum standards regarding the age and service require- 
ments that are to apply for purposes of determining which employ- 
ees are taken into account in determining if a line of business or 
operating unit may be treated as separate. (The standards are to 
apply, for example, for purposes of determining if a line of business 
or operating unit has 50 employees.) Under this authority, the Sec- 
retary could provide that, for such purpose, section 414(q)(8) is to be 
applied without regard to the last sentence thereof, i.e., the em- 
ployer may not elect to reduce the age or service requirements 
specified in the statute. 

The primary purpose for this provision of the bill is to prevent 
the use of nominal age or service requirements to avoid the effect 
of the requirement that, to be treated as separate, a line of busi- 
ness or operating unit is to have 50 employees. 

6. Definition of compensation (sec. lll(k) of the bill, sec. 1115 of 
the Reform Act, and sec. 414(s) of the Code) 

Present Law 

Under present law, except as otherwise provided, "compensa- 
tion" is defined as compensation for services for an employer that 
is includible in gross income. The Secretary is to prescribe regula- 
tions defining compensation for a self-employed individual based on 
this definition applicable to common-law employees. 

The employer may elect whether to include elective deferrals 
(under sees. 125, 402(a)(8), 402(h), or 403(b)) as part of compensation. 
In addition, the Secretary is directed to provide certain alternative 
definitions of compensation that do not favor highly compensated 
employees. 

An employee who at any time during the plan year or any of the 
4 preceding plan years is a 1-percent owner of the employer and 
has annual compensation from the employer of more than $150,000 
is a key employee. 

Explanation of Provision 

The bill modifies the general definition of compensation so that 
it is the same one used (for employees or self-employed individuals, 
whichever is applicable) for purposes of the limit on contributions 
under a defined contribution plan (sec. 415(c)(3)). (The bill does not 
affect the employer's right to elect to include elective deferrals or 
the Secretary's authorization to provide alternative definitions of 
compensation.) This provides greater uniformity, and excludes cer- 
tain items (such as deductible reimbursements of moving expenses) 
that were not intended to be taken into account. It is not the intent 
of the bill, however, to restrict future regulatory modifications of 
the definition of compensation under section 415(c)(3). 

The bill also clarifies that the definition of compensation provid- 
ed in section 414(s) only applies to provisions that specifically refer 



115 

to it. Thus, for example, the definition does not apply for purposes 
of the limits on deductions (sec. 404) or on contributions and bene- 
fits (sec. 415). 

Under the bill, for purposes of determining whether an employee 
is a key employee by virtue of having annual compensation over 
$150,000, compensation means compensation as defined in section 
415(c)(3) plus elective deferrals under sections 125, 402(a)(8), 402(h), 
and 403(b). This is the same definition used for purposes of deter- 
mining whether an employee is highly compensated (sec. 414(q)(7)), 
a determination that is similar to the determination of who is a 
key employee. This provision of the bill applies to years beginning 
after December 31, 1988. 



C. Treatment of Distributions 

1. Uniform minimum distribution rules (sec. lllA(a) of the bill, 
sec. 1121 of the Reform Act, and sees. 402(a)(5), 402(e)(1)(B), 
and 408(d)(3)(A) of the Code) 

Present Law 

Under present law, a uniform benefit commencement date and 
required distribution rules are provided for benefits under all 
qualified plans (sees. 401(a) and 403(a)), IRAs (sec. 408), tax-shelterd 
annuities (sec. 403(b)), and eligible deferred compensation plans of 
State and local governments and tax-exempt employers (sec. 457 
plans). 

The Act repealed the provisions that prohibited rollover distribu- 
tions by or on behalf of 5-percent owners to another qualified plan. 
However, the Act did not repeal the provision that prohibited a 5- 
percent owner from rolling over a qualified plan distribution into a 
conduit IRA and subseqently rolling the distribution over into an- 
other qualified plan. 

Explanation of Provision 

The bill clarifies that a distribution from a qualified plan and 
corresponding distribution to an IRA that results in any portion of 
a distribution being excluded from gross income under the rollover 
provisions is treated as a rollover distribution for purposes of the 
IRA rollover provisions. 

The bill deletes the IRA rollover restriction under which certain 
distributions from IRAs with respect to 5-percent owners are not 
treated as rollover distributions for purposes of the IRA rules. This 
provision is effective for rollover distributions made in taxable 
years beginning after December 31, 1986. Thus, the bill clarifies 
that, as is the case with other taxpayers, 5-percent owners may roll 
over a qualified plan distribution into an IRA and subsequently 
roll the amount distributed from the IRA into another qualified 
plan. Different rules for 5-percent owners and other taxpayers are 
no longer necessary under the Act because all distributions from 
qualified plans are generally subject to the early withdrawal tax 
formerly applicable only to distributions to 5-percent owners. 

Further, the bill provides that, notwithstanding any other provi- 
sion of law, a plan or contract is permitted (except as provided in 
regulations prescribed by the Secretary) to incorporate by reference 
the uniform benefit commencement date and the required distribu- 
tion rules for qualified plans (sec. 401(a)(9)). 

It is further intended that an employee who has not retired from 
an employer prior to 1989, but has attained age 70 Va prior to 1989, 
is considered to have attained age 70 y2 in 1989 for purposes of ap- 

(116) 



117 

plying the new uniform benefit commencement rule to a plan 
maintained by the employer. 

2. Tax treatment of distributions (sec. lllA(b) of the bill, sec. 1122 
of the Reform Act, and sees. 72, 402, and 414 of the Code) 

The Act generally (1) phased out long-term capital gains treat- 
ment over 6 years (except for certain grandfathered individuals); (2) 
eliminated 10-year forward averaging (except for certain grandfa- 
thered individuals) and allowed 5-year forward averaging under 
more limited circumstances; (3) modified the prior-law basis recov- 
ery rules for amounts distributed prior to a participant's annuity 
starting date; (4) repealed the special 3-year basis recovery rule; (5) 
modified the general basis recovery rules for distributions from an 
annuity; (6) provided basis recovery rules for distributions from an 
IRA when an individual has made nondeductible IRA distributions; 
(7) repealed the constructive receipt rule for tax-sheltered annu- 
ities; and (8) modified the rules relating to rollovers of partial dis- 
tributions. 

a. Basis recovery rules 

Present Law 

The Act modified the basis recovery rules applicable to distribu- 
tions from plans to which after-tax employee distributions have 
been made by (1) eliminating the 3-year basis recovery rule for dis- 
tributions on or after the annuity starting date, and (2) requiring, 
with respect to distributions prior to the annuity starting date, 
that basis be recovered on a pro-rata basis. 

Further, present law limits the total amount that an employee 
may exclude from income as a recovery of basis to the total 
amount of the employee's basis. If benefits cease prior to the date 
the basis has been fully recovered, the amount of unrecovered basis 
is allowed as a deduction to the annuitant for his or her last tax- 
able year. These modifications of the basis recovery rules are effec- 
tive with respect to an individual whose annuity starting date is 
after July 1, 1986. 

Under the Act, employee contributions to a defined contribution 
plan (and the income attributable thereto) may be treated as a sep- 
arate contract for purposes of the basis recovery rules. 

Under present law, a special basis recovery rule applies with re- 
spect to a plan substantially all the contributions to which are em- 
ployee contributions (sec. 72(e)(7)). Under this special rule, distribu- 
tions from such a plan are treated first as a return of taxable 
amounts under the plan. 

Explanation of Provision 

The bill provides that, if employee contributions (and the income 
attributable thereto) under a defined benefit plan are credited to a 
separate account that generally is treated as a defined contribution 
plan (sec. 414(k)), then such separate account is also treated as a 
defined contribution plan for purposes of the basis recovery rules. 
The bill clarifies that this separate contract treatment applies 



118 

without regard to whether the distribution is received as an annu- 
ity- 
The bill repeals the special basis recovery rules that apply in the 

case of a plan substantially all of the contributions to which are 
employee contributions. 

The bill provides that the effective date of the provision allowing 
a deduction in the last taxable year of the annuitant for unrecov- 
ered basis is effective for individuals whose annuity starting date is 
after July 1, 1986. Thus, in the case of an individual whose annuity 
starting date is after July 1, 1986, and before January 1, 1987, the 
rule limiting the amount of basis recovered does not apply, but the 
rule providing a deduction at death for unrecovered basis does 
apply. This rule is provided because individuals who lost the bene- 
fit for the 3-year basis recovery rule did not have adequate time to 
consider alternative forms of retirement benefits and it would be 
unfair to deny such individuals the benefit of the deduction for un- 
recovered basis at death. 

The bill provides a special rule with respect to plans maintained 
by a State that, on May 5, 1986, provided for withdrawals to the 
employee of employee contributions (other than as an annuity). In 
the case of such plans, the modifications in the basis recovery rules 
for distributions prior to the annuity starting date apply only to 
the extent that the amount distributed exceeds the employee's 
basis as of December 31, 1986. In addition, amounts received (other 
than as an annuity) before or with the first annuity payment are 
treated as having been recovered before the annuity starting date. 

b. Rollovers 

Present Law 

The Act modified the rules relating to rollovers of partial distri- 
butions. Under the Act, partial distributions may be rolled over 
only if the distribution would satisfy the requirements for a lump- 
sum distribution and if the distribution is made on account of the 
death of the employee, the employee's separation from service, or is 
made after the employee has become disabled. The rule aggregat- 
ing plans of the same kind applies for purposes of determining 
whether the amount distributed constitutes 50 percent of the bal- 
ance to the credit of an employee (sec. 402(e)(4)(C)). 

The Act contained a special rule permitting certain amounts de- 
posited in certain financially distressed financial institutions to be 
rolled over notwithstanding that the rollover does not occur within 
60 days of the date of the original distribution. Under this rule, the 
60-day period does not include periods while the deposit is frozen. 
In addition, the individual has a minimum of 10 days after the re- 
lease of the frozen deposit to complete the rollover. 

Explanation of Provision 

The bill clarifies that a partial distribution may be rolled over 
only if the distribution would satisfy the requirements for a lump- 
sum distribution if at least 50 percent of the balance to the credit 
of an employee is used rather than the balance to the credit of the 
employee in applying the test for lump-sum distribution treatment. 



119 

For purposes of determining whether a partial distribution may be 
rolled over, the 5 years of participation and the election require- 
ments applicable to lump-sum distributions do not apply (sees. 
402(e)(4)(B) and (H)). 

The bill clarifies that the special rule for frozen deposits applies 
only to amounts that are frozen within 60 days of the date that the 
amounts are distributed from the plan. 

c. Net unrealized appreciation 

Present Law 

Under present law, to the extent provided by the Secretary, a 
taxpayer may elect to waive the special treatment of net unreal- 
ized appreciation in employer securities with respect to a lump-sum 
distribution prior to the time the distribution is received. 

Explanation of Provision 

Under the bill, the election to waive net unrealized appreciation 
treatment with respect to a lump-sum distribution is to be made on 
the tax return on which the distribution is required to be included 
in gross income if the special treatment is waived. This change is 
designed to give taxpayers more time to determine whether or not 
they make the election. An election to waive the special treatment 
of net unrealized appreciation does not preclude an election for 
income averaging. 

d. Income averaging and long-term capital gains treatment 

Present Law 

The Act generally repealed 10-year forward averaging, phased 
out pre-1974 capital gains treatment over a 6-year period, and 
made 5-year forward averaging (calculated in the same manner as 
10-year averaging under prior law) available for 1 lump-sum distri- 
bution with respect to an employee on or after the taxpayer attains 
age 59 Va. 

In addition, the Act provided a special transition rule under 
which an individual who had attained age 50 by January 1, 1986, is 
entitled to make 1 election to use 5-year averaging (under the new 
tax rates) or 10-year averaging (under the prior-law tax rates) with 
respect to a single lump-sum distribution. Similarly, such a grand- 
fathered individual could elect capital gains treatment with respect 
to a lump-sum distribution without regard to the 6-year phaseout 
of capital gains treatment. Under this special capital gains elec- 
tion, the portion of a lump-sum distribution entitled to capital 
gains treatment is taxed at a rate of 20 percent, regardless of the 
maximum effective capital gains rate under prior law. 

Under prior law, the amount subject to tax under the income 
averaging rule was calculated by adding in the zero bracket 
amount. This addition was eliminated by the Act because the zero 
bracket amount is eliminated generally. 



120 

Explanation of Provision 

The bill clarifies that a 5-year averaging election may be made 
by an individual, trust, or estate for a lump-sum distribution re- 
ceived with respect to an employee who had attained age 59 y2. In 
addition, the bill provides that an income averaging election or 
election of long-term capital gains treatment under the special 
transition rules may be made by any individual, trust, or estate 
with respect to an employee who had attained age 50 by January 1, 
1986. 

The bill also clarifies that, for purposes of 5-year income averag- 
ing, the phaseout of the 15-percent bracket applies. 

Further, under the bill, the election under the special transition 
rule of 10-year averaging (under the prior-law tax rates) is to take 
into account the prior-law zero bracket amount. This change is 
needed to preserve the prior-law treatment for persons who elect 
the grandfather rule. 

The bill clarifies that a capital gains election made under either 
of the special transition rules is treated as an income averaging 
election (within meaning of sec. 402(e)(4)(B)) for all purposes under 
the Code (including, of example, sec. 4980 A relating to the 15-per- 
cent tax on excess distributions). 

3. Additional income tax on early withdrawals (sec. lllA(c) of the 
bill, sec. 1123 of the Reform Act, and sec. 72 of the Code) 

The Act (1) modified the withdrawal restrictions applicable to 
qualified cash or deferred arrangements, tax-sheltered annuities, 
and tax-sheltered custodial accounts, and (2) imposed a 10-percent 
additional income tax on certain early withdrav/als from qualified 
retirement plans. 

A qualified retirement plan is defined to include (1) a qualified 
plan (sec. 401(a)), (2) a qualified annuity plan (sec. 403(a)), (3) a tax- 
sheltered annuity or custodial account (sec. 403(b)), or (4) an indi- 
vidual retirement arrangement (IRA) (sec. 408). 

a. Early retirement exception 

Present Law 

Under the Act, the additional income tax on early withdrawals 
does not apply to distributions that are made to an employee after 
separation from service on account of early retirement under the 
plan after attainment of age 55. This exception does not apply to 
distributions from an IRA. 

In all cases, the exception applies only if the participant has at- 
tained age 55 on or before separation from service. Thus, for exam- 
ple, the exception does not apply to a participant who separates 
from service at .age 52 and begins receiving benefits at or after age 
55. 

Explanation of Provision 

The bill modifies the early retirement exception to apply in any 
case in which an employee receives a distribution on account of 
separation from service after attainment of age 55, rather than re- 
quiring an early retirement under the plan. The intent of this pro- 



121 

vision is to eliminate what is considered a requirement that has 
little substantive effect, but could require plan amendment. 

The modified early retirement exception continues to apply if the 
employee returns to work for the same emloyer (or for a different 
employer) as long as the employee did, in fact, separate from serv- 
ice before the plan distribution. Of course, any short-term separa- 
tion is to be closely scrutinized to determine if it is a bona fide, in- 
definite separation from service that would qualify for this excep- 
tion to the early withdrawal tax. 

As under present law, this exception does not apply to IRA dis- 
tributions. 

b. Exception for distributions from ESOPs 
Present Law 

Under present law, certain contributions from an employee stock 
ownership plan (ESOP) are exempt from the additional income tax 
on early withdrawals. Under the Act, this exception applies to the 
extent that, on average, a majority of assets in the plan have been 
invested in employer securities for the 5-plan year period preceding 
the plan year in which the distribution is made and the exception 
does not apply to any distribution attributable to assets that have 
not been invested in employer securities at all times during such 5- 
plan year period. 

Explanation of Provision 

The bill modifies the ESOP exception to the additional income 
tax on early withdrawals to provide that the exception is available 
to the extent that a distribution from an ESOP is attributable to 
assets that have been invested, at all times, in employer securities 
(as defined in sec. 409(1)) that satisfy the requirements of sections 
409 and 401(a)(28) for the 5-plan year period immediately preceding 
the plan year in which the distribution occurs. Employer securities 
that are transferred to an ESOP from another plan are also eligi- 
ble for the exception to the early withdrawal tax as long as the 
holding period requirement is satisfied with respect to such em- 
ployer securities taking into account the time such employer secu- 
rities were held in the other plan. 

For example, assume that employer securities that were trans- 
ferred from a profit-sharing plan are held in an ESOP for the 1- 
plan year period immediately preceding the plan year in which the 
distribution is made. If the profit-sharing plan met the require- 
ments of sections 401(a)(28) and 409 for the 4-plan year period im- 
mediately prior to the transfer to the ESOP, then the holding 
period requirement is satisfied. On the other hand, if the profit- 
sharing plan did not satisfy sections 401(a)(28) and 409, the holding 
period requirement would not be satisfied and the exception to the 
early withdrawal tax does not apply. The bill clarifies that the em- 
ployer securities are not required to be subject to the requirements 
of sections 401(a)(28) and 409 prior to the time those requirements 
are effective. 



122 

These changes are designed to ensure that the ESOP exception 
only applies with respect to employer securities that are subject to 
the rules applicable to ESOPs. 

Under the bill, an ESOP includes both an ESOP described in sec- 
tion 4975(e)(7) and a tax-credit ESOP (within the meaning of sec. 
409). 

c. Exceptions not applicable to IRAs 

Present Law 

Under present law, certain exceptions to the additional income 
tax on early withdrawals are not applicable to distributions from 
IRAs. These exceptions include the early retirement, medical ex- 
pense, and ESOP exceptions. The exception for distributions pursu- 
ant to a qualified domestic relations order applies to an IRA only 
to the extent the IRA is subject to the rules relating to qualified 
domestic relations orders. 

Explanation of Provision 

Because the rules relating to qualified domestic relations orders 
do not apply to IRAs, the bill clarifies that the exception to the 
early withdrawal tax in the case of distributions pursuant to a 
qualified domestic relations order does not apply to IRA distribu- 
tions. This is consistent with the pre-Reform Act law applicable to 
IRAs. 

d. Deferred annuity contracts 

Present Law 

Under present law, early withdrawals from a deferred annuity 
contract generally are subject to a 10-percent additional income tax 
in the same manner as early withdrawals from a qualified plan. 

Certain exception to the 10-percent early withdrawal tax are pro- 
vided. An exception is provided for a distribution that is part of a 
series of substantially equal periodic payments (not less frequently 
than annually) made over the life or life expectancy of the taxpay- 
er or the lives or life expectancies of the taxpayer and the taxpay- 
er's beneficiary. 

If distributions to an individual are not subject to the tax be- 
cause of application of the substantially equal payment exception, 
the tax will nevertheless be imposed if the employee changes the 
distribution method prior to age 59 y2 to a method that does not 
qualify for the exception. The additional tax will be imposed in the 
first taxable year in which the modification is made and will be 
equal to the tax (as determined under regulations) that would have 
been imposed had the exception not applied. 

In addition, the recapture tax will apply if an employee does not 
receive payments under a method that qualifies for the exception 
for at least 5 years, even if the method of distribution is modified 
after the employee attains age 59 Va. Thus, for example, if an em- 
ployee begins receiving payments in substantially equal install- 
ments at age 56, and alters the distribution method to a form that 
does not qualify for the exception prior to attainment of age 61, the 



123 

additional tax will be imposed on amounts distributed prior to age 
59 Va as if the exception had not applied. The additional tax will not 
be imposed on amounts distributed after attainment of age 59 ¥2. 

The modifications to the additional income tax on early with- 
drawals under a deferred annuity apply to all distributions made 
under the annuity in taxable years beginning after December 31, 
1986. 

Explanation of Provision 

The bill clarifies that the substantially equal payment exception 
and the recapture tax for; distributions in violation of the substan- 
tially equal payment exception are not limited to distributions to 
employees under an employer-maintained pension plan. Rather, 
the exception and recapture tax apply to all distributions under a 
deferred annuity whether or not received by an individual with re- 
spect to the individual's status as an employee. 

Further, the bill clarifies that the additional income tax applica- 
ble to early withdrawal from a deferred annuity (sec. 72(q)) does 
not apply if a distribution is otherwise subject to the early with- 
drawal rules for qualified plans (sec. 72(t)), whether or not an ex- 
ception to the additional income tax on early withdrawals from a 
qualified plan applies under section 72(t)(2). 

The bill modifies the effective date of the provision relating to 
the additional income tax on early withdrawals under a deferred 
annuity so that the changes in the early withdrawal tax does not 
apply to any distribution under an annuity contract if (1) as of 
March 1, 1986, payments were being made under such contract 
pursuant to a written election providing a specific schedule for the 
distribution of the taxpayer's interest in such contract, and (2) such 
distribution is made pursuant to such written election. 

e. Substantially equal payment exception 
Present Law 

Under present law, an exception to the 10-percent additional 
income tax on early withdrawals from a qualified plan or deferred 
annuity is provided for a distribution that is part of a series of sub- 
stantially equal periodic payments made (not less frequently than 
annually) over the life or life expectancy of the taxpayer or the 
lives or life expectancies of the taxpayer and the taxpayer's benefi- 
ciary. 

Explanation of Provision 

The bill provides that the substantially equal payment exception 
is available only if the beneficiary whose life or life expectancy is 
taken into account in determining whether the exception is satis- 
fied is a designated beneficiary of the individual. For this purpose, 
rules similar to those applicable under section 401(a)(9) are to 
apply. 



124 

f. Qualifled voluntary employee contributions 

Present Law 

Under prior law, an employee who was a participant in a quali- 
fied plan, tax-sheltered annuity program, or government plan was 
allowed a deduction for qualified voluntary employee contributions 
(QVECs) made by or on behalf of the employee to the plan. The Act 
repealed the deduction allowed for QVECs, but permitted contribu- 
tions that had been made prior to repeal to continue to be held 
under the plan. 

Under present law, in addition to the additional income tax on 
early withdrawals under qualified plans (sec. 72(t)), a 10-percent ad- 
ditional income tax is also imposed on early withdrawals of QVECs 
(sec. 72(o)). 

Explanation of Provision 

In order to prevent the imposition of two 10-percent early with- 
drawal taxes on distributions attributable to QVECs, the bill re- 
peals the 10-percent early withdrawal tax applicable only to 
QVECs. Thus QVECs are treated as distributions from a qualified 
plan for purposes of the 10-percent additional income tax on early 
withdrawals and are eligible for any of the applicable exceptions 
otherwise available for distributions from qualified plans. 

g. Tax-sheltered annuities 

Present Law 

The Act provided that the withdrawal restrictions applicable to 
tax-sheltered custodial accounts generally were extended to elective 
deferrals and earnings on elective deferrals under other tax-shel- 
tered annuities. Under these rules, early distributions from elective 
deferrals and earnings on elective deferrals under a tax-sheltered 
annuity are prohibited unless the withdrawal is made on account 
of death, disability, separation from service, or attainment of age 
59 ¥2. In addition, withdrawals on account of hardship from a tax- 
sheltered annuity or custodial account are permitted only to the 
extent of the contributions made pursuant to a salary reduction 
agreement (but not earnings on those contributions). 

Under the Act, the provisions restricting distributions attributa- 
ble to elective deferrals (and earnings thereon) under a tax-shel- 
tered annuity are effective for taxable years beginning after De- 
cember 31, 1988. 

Explanation of Provision 

The bill provides that the distribution restrictions added by the 
Act with respect to tax-sheltered annuities are effective for years 
beginning after December 31, 1988, but only with respect to distri- 
butions from such tax-sheltered annuities that are attributable to 
assets that were not held as of the close of the last year beginning 
before January 1, 1989. Thus, the new rules apply to contributions 
made in years beginning after December 31, 1988, and to earnings 



125 

on those contributions and on amounts held as of the last year be- 
ginning before January 1, 1989. 

h. Involuntary cashouts under a qualified plan 
Present Law 

Under present law, a pension plan may immediately distribute 
the present value of an employee's benefit under the plan if the 
employee separates from service with the employer and the present 
value of the benefit does not exceed $3,500. It was unclear under 
the Act whether the 10-percent additional income tax on early 
withdrawals under a qualified plan applies in the case of such in- 
voluntary cashouts of benefits. 

Explanation of Provision 

The bill clarifies that the additional income tax on early with- 
drawals under a qualified plan is to apply in the case of an invol- 
untary cashout. Of course, the early withdrawal tax does not apply 
if the amount of the benefit paid to an employee is rolled over to 
another qualified plan or an IRA. 

4. Transition rule (sec. lllA(d) of the bill and sec. 1124 of the 
Reform Act) 

Present Law 

Under the Act, a special transition rule was provided in the case 
of employees who separated from service during 1986. In the case 
of such an employee, if the employee received a lump-sum distribu- 
tion before March 16, 1987, on account of the separation from serv- 
ice, then the employee could treat the lump-sum distribution as re- 
ceived in 1986 for all purposes. Thus, the lump-sum distribution is 
includible in income in 1986 and, assuming the employee is other- 
wise eligible, the employee can elect 10-year income averaging with 
respect to the lump-sum distribution. 

Explanation of Provision 

Under the bill, the special transition rule is amended to apply in 
the case of an employee who dies, separates from service, or be- 
comes disabled at any time before 1987, including years prior to 
1986. In the case of such an employee, if an individual, trust, or 
estate receives a lump-sum distribution with respect to the employ- 
ee after December 31, 1986, and before March 16, 1987, on account 
of the employee's death, separation from service, or disability, then 
the individual, trust, or estate may treat the distribution as if it 
was received in 1986 for all purposes under the Code. This restruc- 
turing of the rule is intended to make it clear that (1) an individ- 
ual, trust, or estate may elect the transition rule with respect to a 
lump-sum distribution received for an employee who otherwise 
would qualify for the transition rule and (2) a separation from serv- 
ice on account of death or disability is also a separation from serv- 
ice for purposes of the transition rule. 

The bill also clarifies that, for purposes of the transition rule, the 
5 years of participation requirement (sec. 402(e)(4)(H)) and the elec- 



126 

tion requirement (sec. 402(e)(4)(B)) applicable to lump-sum distribu- 
tions do not apply. 

5. Loans from quali^ed plans (sec. lllA(h) of the bill, sec. 1134 of 
the Reform Act, and sec. 72(p) of the Code) 

Present Law 

Under present law, an individual is permitted to borrow from a 
qualified plan in which the individual participates (and to use his 
or her accrued benefit as security for the loan) if certain require- 
ments are satisfied. 

Subject to certain exceptions, a loan to a plan participant is 
treated as a taxable distribution of plan benefits under present 
law. 

Present law provides for the disallowance of the deduction for in- 
terest paid on a loan from a qualified plan by (1) all employees on 
loans secured by elective deferrals (or the income attributable 
thereto) under a qualified cash or deferred arrangement or tax- 
sheltered annuity or custodial account, and (2) key employees with 
respect to loans from any qualified plan or t£ix-sheltered annuity or 
custodial account. 

Explanation of Provision 

Present law does not expressly prescribe the period during which 
the interest deduction disallowance rule applies. Therefore, the bill 
clarifies the period during which the interest deduction disallow- 
ance rule applies to include the period (1) on or after the first day 
on which the individual to whom a loan is made is a key employee 
or (2) the loan is secured by elective deferrals under a qualified 
cash or deferred arrangement or tax-sheltered annuity or custodial 
account. 



D. Limits on Tax Deferral Under QualiHed Plans 

1. Overall limits on contributions and beneHts under qualifled 
plans (sec. 111(d) of the bill, sec. 1106 of the Reform Act, and 
sees. 404 and 415 of the Code) 

The Act revised the overall limits on contributions and benefits 
under qualified plans, tax-sheltered annuity programs, and SEPs. 
In addition, the Act (1) provides special rules with respect to plans 
of governmental employers and tax-exempt employers, (2) permit- 
ted a defined benefit pension plan to maintain a qualified cost-of- 
living arrangement under which employer and employee contribu- 
tions may be applied to provide cost-of-living increases to the pri- 
mary retirement benefit under the plan, (3) imposed a limit on the 
amount of compensation that may be taken into account for deduc- 
tion purposes, and (4) modified the rules relating to the phasein of 
the limits on annual benefits under a defined benefit pension plan. 

a. Includible compensation 

Present Law 

Under present law, not more than $200,000 of compensation of 
an employee may be taken into account under a qualified plan. 
This $200,000 limit on includible compensation applies for most 
purposes under the Code, including the provisions relating to non- 
discrimination requirements and to deductibility. Consequently, no 
more than $200,000 of an employee's compensation for a year may 
be taken into account in computing deductions for plan contribu- 
tions. 

This $200,000 limit is to be adjusted, beginning in 1990, for post- 
1988 cost-of-living increases at the time and in the manner provid- 
ed for the adjustment of the limits on annual benefits under a 
qualified defined benefit pension plan (sec. 415(d)). 

Explanation of Provision 

Under the bill, increases in the $200,000 limit on includible com- 
pensation may not be taken into account before they occur in de- 
termining the deduction limit for contributions to a qualified plan. 
Similarly, such increases may not be taken into account before 
they occur in calculating the full funding limitation (as determined 
under sec. 412). 

Further, the bill makes it clear that the $200,000 cap on includ- 
ible compensation does not apply, under present law, in the case of 
an employer's deduction for benefits provided under a nonqualified 
deferred compensation plan. 



(127) 



128 

b. Eligibility to receive maximum beneHts 

Present Law 

Under the Act, a reduced dollar limit applies to participants who 
have completed fewer than 10 years of participation in a defined 
benefit pension plan (sec. 415(b)(5)). With respect to such partici- 
pants, the dollar limit is determined by multiplying the otherwise 
applicable dollar limit by a fraction. The numerator of the fraction 
is the number of years (including a fractional year) of participation 
in the plan completed by the employee. The denominator of the 
fraction is 10. 

The Act provides that, to the extent provided in regulations, the 
reduction based on years of participation is to be applied separately 
with respect to each change in the benefit structure of a plan by a 
plan amendment or otherwise as if such change is a new plan. This 
phasein for each change in benefit structure begins on the date a 
plan amendment creating the change is effective. 

A separate phase-in rule applies to the 100-percent of compensa- 
tion limit (sec. 415(b)(1)(B)) and to the $10,000 limit on de minimis 
benefits (sec. 415(b)(4)). Under this rule, those limits are phased in 
on the basis of years of service rather than years of participation. 

Explanation of Provision 

The bill clarifies that the rule requiring separate phaseins for 
each change in benefit structure under a plan does not apply in the 
case of the phasein of the 100 percent of compensation limit or the 
$10,000 limit on de minimis benefits. 

c. QualiHed cost-of-living arrangements 

Present Law 

In general 

The Act permitted a defined benefit pension plan to maintain a 
qualified cost-of-living arrangement under which employer and em- 
ployee contributions may be applied to provide cost-of-living in- 
creases to the primary benefit under the plan. If the arrangement 
is qualified, then an employee contribution under the arrangement 
is not to be treated as an annual addition in applying the separate 
limit on annual additions under defined contribution plans (sec. 
415(c)), but is to be treated as an annual addition for purposes of 
applying the combined plan limit (sec. 415(e)). Further, under a 
qualified arrangement, the benefit attributable to an employee's 
contribution is to be treated as a benefit derived from employer 
contributions for purposes of applying the limit on annual benefits 
(sec. 415(b)). Under the Act, a qualified cost-of-living arrangement 
is required to comply with the dollar limits, election procedures, 
and nondiscrimination requirements of the Act. 

Limit requirement 

A qualified cost-of-living arrangement satisfies the limit require- 
ment provided by the Act if it (1) limits cost-of-living adjustments 
to those cost-of-living increases occurring after the annuity starting 



129 

date, and (2) bases the cost-of-living adjustment on average cost-of- 
living increases determined by reference to 1 or more indices pre- 
scribed by the Secretary, except that the plan can provide a mini- 
mum increase for each year of 3 percent of the original retirement 
benefit. It was unclear, under the Act, whether a plan could pro- 
vide for a minimum increase for each year of 3 percent of the re- 
tirement benefit as adjusted under the cost-of-living arrangement 
in prior years. 

Election requirement 

A qualified cost-of-living arrangement meets the election require- 
ments if it provides that participation in the qualified cost-of-living 
arrangement is elective and permits participants to make an elec- 
tion in (1) the year in which the participant attains the age at 
which retirement benefits are first available under the defined ben- 
efit pension plan; (2) the year in which the participant separates 
from service; or (3) both such years. 

Explanation of Provision 
Limit requirement 

The bill clarifies that a plan will not fail to satisfy the limit re- 
quirement if it provides for a minimum increase for each year of 3 
percent of the retirement benefit (determined without regard to the 
current year's increase). Thus, the minimum increase may be 3 
percent of the retirement benefit as adjusted under the cost-of- 
living arrangement in prior years. 

Election requirement 

Under the bill, a plan may permit participants to make an elec- 
tion under the qualified cost-of-living arrangement during any 
year, as long as the plan permits elections to be made at least in 
the year in which the participant (1) attains the earliest retirement 
age under the defined benefit pension plan (determined without 
regard to any requirement of separation from service), or (2) sepa- 
rates from service. 

d. Computation of combined limit 
Present Law 

Under a transition rule of the Act, in the case of a plan that sat- 
isfied the requirements of the overall limits on contributions and 
benefits (sec. 415) for its last year beginning before January 1, 1987, 
Treasury regulations are to provide for the determination of an 
amount thai is to be subtracted from the numerator of the defined 
contribution fraction so that the sum of the defined benefit plan 
fraction and the defined contribution plan fraction (sec. 415(e)(1)) 
does not exceed 1.0 for such year. This amount to be subtracted is 
not to exceed the numerator of the fraction. 

Explanation of Provision 

The bill clarifies that the adjustment to the sum of the defined 
benefit plan fraction and the defined contribution fraction so that 



130 

such sum does not exceed 1.0 for purposes of this transition rule is 
determined as if the new rules were in effect for the last year be- 
ginning before January 1, 1987. 

2. Deduction limits for qualified plans (sec. lllA of the bill, sec. 
1131 of the Reform Act, and sec. 4972 of the Code) 

Present Law 
In general 

Under present law, a 10-percent nondeductible excise tax is im- 
posed on nondeductible contributions to a qualified plan (sees. 
401(a) and 403(a)) or simplified employee pension (SEP) (sec. 408(k)). 

Amount of nondeductible contributions 

The contributions to a plan that are subject to the excise tax on 
nondeductible contributions are (1) the amounts contributed to a 
qualified employer plan by the employer for the taxable year in 
excess of the amount allowable as a deduction for the taxable year, 
plus (2) the unapplied amounts in the preceding taxable year. The 
unapplied amounts in the preceding taxable year are the amounts 
subject to the excise tax in the preceding year reduced by the sum 
of (1) the portion of the amounts that are returned to the employer 
during the taxable year, and (2) the portion of such unapplied 
amounts that are deductible during the current taxable year. 

Time for determination of nondeductible contributions 

Nondeductible contributions for a year are determined as of the 
close of the employer's taxable year. A contribution made on ac- 
count of a year that is made after the close of the year is to be 
taken into account in determining the level of excess contributions 
for the year with respect to which the contribution is made. 

Nondeductible contributions to underfunded plans 

Under the Act, the excise tax on nondeductible contributions ap- 
plies to nondeductible contributions to underfunded plans. 

Definition of employer 

The excise tax on nondeductible contributions is imposed on the 
employer. Under present law, in the case of a plan that provides 
contributions or benefits for employees some or all of whom are 
self-employed individuals (sec. 401(c)(1)), an individual who owns 
the entire interest in an unincorporated trade or business is treat- 
ed as the employer. Also, under present law, a partnership is to be 
treated as the employer of each partner who is considered to be an 
employee (sec. 401(c)(1)). 

Under the Act, an employer to whom the excise tax on nonde- 
ductible contributions applies includes an employer that is a tax- 
exempt organization. 



131 

Explanation of Provision 
Amount of nondeductible contributions 

Under the bill, the definition of nondeductible contributions in- 
cludes, for purposes of the excise tax, contributions allocable to the 
purchase of life, accident, health, or other insurance on behalf of a 
self-employed individual, but only to the extent that the contribu- 
tions would be nondeductible without regard to the special rule 
limiting deductions for such contributions (sec. 404(e)). 

The bill clarifies that the amount allowable as a deduction (with- 
out regard to sec. 404(e)) for any taxable year is treated as coming 
first from carryforwards to the taxable year from preceding taxable 
years (in order of time) and then from employer contributions 
made during the taxable year. 

Further, under the bill, the unapplied amounts in the preceding 
taxable year do not include nondeductible contributions made for 
years prior to the effective date of the excise tax on nondeductible 
contributions. However, in determining whether contributions after 
the effective date are subject to the excise tax, carryforwards from 
pre-effective date years are applied first against the deduction limit 
(without regard to sec. 404(e)). 

Time for determination of nondeductible contributions 

Because the determination of nondeductible contributions as of 
the end of a taxable year includes contributions made after the 
close of the taxable year with respect to the year, the bill provides 
that contributions that are returned (together with the income allo- 
cable thereto) to an employer (to the extent permitted under sec. 
401(a)(2)) by the due date of plan contributions for the year (sec. 
404(aX6)) are not treated as nondeductible contributions subject to 
the excise tax. 

Nondeductible contributions to underfunded plans 

Under the bill, the excise tax on nondeductible contributions 
does not apply in the case of a plan that is underfunded and to 
which Title IV of ERISA applies. A plan is underfunded if, as of 
the close of the plan year with or within which the taxable year 
begins, (1) the liabilities of the plan (determined as if the plan v/ere 
terminated on that date) exceed (2) the assets of the plan. In the 
case of such an underfunded plan, contributions for a plan year up 
to the excess calculated under the preceding sentence are not sub- 
ject to the excise tax even if such contributions are not deductible 
by the employer. 

Definition of employer 

The bill provides that the excise tax on nondeductible contribu- 
tions does not apply in the case of an employer that has been 
exempt from income tax at all times. Under rules to be prescribed 
by the Secretary, this exception does not apply to the extent that 
the employer has been subject to unrelated business income tax or 
has otherwise derived a tax benefit from the qualified plan. 

The original rationale for the excise tax was that, by making 
nondeductible contributions to qualified plans, often the benefit of 
tax-free growth on the amounts contributed outweighed the delay 



132 

in the employer's deduction for plan contributions. Such an incen- 
tive to make nondeductible contributions increased the likelihood 
that employers would use qualified plans as a tax-favored savings 
vehicle, particularly in the case of small plans that primarily bene- 
fit the owners of the employer. The excise tax on reversions may 
not offset the value of the deferral of tax on earnings on nonde- 
ductible contributions to qualified plans. 

Such a rationale does not apply in the case of contributions to 
plans maintained by governments or tax-exempt organizations. In 
the case of such plans, the employer generally has no incentive to 
make plan contributions solely to receive the benefit of tax-free 
growth because the employer could hold the funds directly without 
incurring current income tax. Thus, an incentive to use a qualified 
plan as a tax-favored savings vehicle generally does not exist in the 
case of a qualified plan maintained by a government or tax-exempt 
employer. 

Effective Date 

The bill provides a delayed effective date for the changes in the 
deduction rules for plans maintained pursuant to a collective bar- 
gaining agreement (see the discussion in Part E, below). 

3. Excise tax on reversion of quallHed plan assets to employer 
(sec. lllA(f) of the bill, sec. 1132 of the Reform Act, and sec. 
4980 of the Code) 

Present Law 
In general 

Under present law, a 10-percent excise tax is imposed on a rever- 
sion from a qualified plan. The excise tax is imposed on the em- 
ployer maintaining the plan. 

Present law defines a reversion as the amount of cash and the 
fair market value of other property received (directly or indirectly) 
by an employer from a qualified plan. No inference is to be drawn 
from the definition of a reversion as to the income tax conse- 
quences and the effect on a plan's qualified status of a transfer of 
assets from a qualified plan that has not been terminated to an- 
other qualified plan. 

Special rule for assets transferred to ESOPs 

Present law provides an exception to the excise tax on reversions 
in the case of transfers of assets from a defined benefit pension 
plan to an employee stock ownership plan (ESOP). The amount 
transferred is not includible in the income of the employer, nor is 
the amount transferred deductible by the employer as a plan con- 
tribution. No inference is to be drawn from this exception as to the 
circumstances in which asset transfers will or will not satisfy the 
exclusive benefit rule and any other applicable qualification re- 
quirements (e.g., sec. 414(1)). 

Under present law, the amount transferred to the ESOP is re- 
quired to be used, within 90 days after the transfer, to acquire em- 
ployer securities (as defined in sec. 409(1)) or used to repay a loan 



133 

the proceeds of which are or were used to acquire employer securi- 
ties. 

The employer securities acquired with the amounts transferred 
are to be allocated immediately under the plan to ESOP partici- 
pants, subject to the limits under section 415. As provided under 
the plan, the amount transferred but not allocated in the year of 
transfer (by reasons of the limitation of sec. 415) may be held in a 
suspense account pending allocation (provided allocations of the 
amounts in the suspense account are made no more slowly than 
ratably over a 7-year period). 

The employer securities acquired with the transferred assets are 
to be held under the plan until distributed to plan participants. 

The special exception for transfers to an ESOP does not apply to 
transfers occurring on or after January 1, 1989, unless the transfer 
occurs on account of a plan termination before January 1, 1989. 

Explanation of Provision 

The bill clarifies that the exception to the excise tax on rever- 
sions in the case of transfers of assets to an ESOP applies to trans- 
fers to tax-credit ESOPs (sec. 409) as well as ESOPs described in 
section 4975(e)(7). Absent this clarification, a tax-credit ESOP 
would be required, in order to qualify for the ESOP exception, to 
add plan langauage applicable to leveraged ESOPs even if the 
ESOP did not have any outstanding loans. 

The bill provides an exception to the rule that the employer se- 
curities acquired with transferred assets are to be held under the 
plan until distributed to plan participants. Under this exception, 
the transferred amounts are not required to be held in employer 
securities if a plan participant elects to diversify a portion of the 
participant's account balance (under the rules of sec. 401(a)(28)) and 
diversification cannot be satisfied out of nontransferred assets. 

In addition, the bill provides that, with respect to the allocation 
of employer securities, the miminim amount required to be allocat- 
ed to participants' accounts in the ESOP in the year in which the 
transfer occurs is not to be less than the lesser of (1) the maximum 
amount that could be allocated without violating the requirements 
of section 415, or (2) Vs of the total amount transferred. Thus, the 
requirement in the Reform Act that amounts transferred to an 
ESOP are required to be allocated in the year of transfer up to the 
maximum amount permitted to be allocated under the limits on 
contributions (sec. 415) is repealed. 

Finally, the bill clarifies the exception for transfers to ESOPs to 
the general rule that the employer is required to include the 
amount of any reversion in income. Under the bill, the exception to 
the income inclusion requirement applies to any reversion occur- 
ring after March 31, 1985, if the reversion is transferred to an 
ESOP, subject to the general Januay 1, 1989, termination of the 
ESOP exception. 



134 

4. Excise tax on excess distributions from qualified retirement 
plans (sec. lllA(g) of the bill, sec. 1133 of the Reform Act, 
and sec. 4981A of the Code) 

Under the Act, an excise tax is imposed on excess distributions 
from qualified retirement plans, tax-sheltered annuities, and IRAs. 
To the extent that aggregate annual distributions paid to a partici- 
pant from such tax-favored retirement arrangements are excess 
distributions, the Act generally imposes an excise tax equal to 15 
percent of the excess. The excise tax will be reduced by the amount 
of tax on the distribution under the provision applying a 10-percent 
additional income tax on early withdrawals. 

a. Definition of excess distributions 

Present Law 

Under the Act, excess distributions are defined as the aggregate 
amount of retirement distributions made with respect to any indi- 
vidual during any calendar year, to the extent such amounts 
exceed $112,500 (adjusted at the same time and in the same 
manner as the dollar limitation on annual benefits under a defined 
benefit pension plan). 

The Act provided a special elective grandfather rule with respect 
to benefits accrued as of August 1, 1986. If this grandfather rule is 
not elected, then the definition of excess distributions is the greater 
of (1) $112,500 (adjusted at the same time and in the same manner 
as the dollar limitation on annual benefits under a defined benefit 
pension plan) or (2) $150,000. 

Explanation of Provision 

The operation of the grandfather provision of the Act in effect 
overrode the general definition of excess distributions in the Act. 
Thus, the general definition of excess distributions is the agggre- 
gate amount of retirement distributions made with respect to any 
individual during any calendar year, to the extent such amounts 
exceed the greater of (1) $112,500 (adjusted at the same time and in 
the same manner as the dollar limitation on annual benefits under 
a defined benefit pension plan), or (2) $150,000. The bill restruc- 
tures the provision to make the general rule clear. 

b. Distributions subject to the tax 

Present Law 

In determining the amount of retirement distributions that are 
subject to the excise tax, aggregate annual distributions made with 
respect to an individual from all pension, profit-sharing, stock 
bonus, and annuity plans, IRAs, and tax-sheltered annuities gener- 
ally are taken into account, regardless of the form of the distribu- 
tion or the number of recipients. 

Under the Act, however, certain amounts are excluded in deter- 
mining such aggregate annual distributions. Excludable distribu- 
tions include (1) amounts representing a return of an employee's 
after-tax contributions (but not earning thereon) or other amounts 
that are treated as part of the employee's investment in the con- 



135 

tract, (2) amounts excluded from the recipient's income because 
they are rolled over into another plan or an IRA, and (3) amounts 
excluded from the participant's income because they are payable to 
a former spouse pursuant to a qualified domestic relations order 
(sec. 414(p)) and includible in the spouse's income. 

Explanation of Provision 

The bill clarifies that the exception to the amounts taken into ac- 
count in determining aggregate annual distributions under a plan 
for investment in the contract is not limited to an employee's in- 
vestment in the contract under a qualified plan, but also includes 
an individual's investment in the contract under an IRA. The Act 
was not intended to limit the exception for investment in the con- 
tract to amounts received by employees in their capacity as such. 

In addition, the bill provides that, in the case of an annuty con- 
tract that is distributed to an individual and not included in the 
individual's income when the contract is distributed, the distribu- 
tion of the contract is disregarded in applying this excise tax. 
Rather, payments made under or received for such an annuity 
contract are treated as retirement distributions subject to the 
excise tax to the extent they are excess distributions. 

In order to identify only those qualified plan distributions that 
represent a payment of a benefit under the plan, the bill provides 
that certain amounts returned to an employee under a qualified 
cash or deferred arrangement or a plan subject to the special non- 
discrimination requirements for employee contributions and em- 
ployer matching contributions are not treated as part of the aggre- 
gate annual distributions under a plan. Thus, under the bill, aggre- 
gate annual distributions do not include a distribution, with re- 
spect to an individual, of excess deferrals (as defined in sec. 402(g)), 
excess contributions (as defined in sec. 401(k)(8)), excess aggregate 
contributions (as defined in sec. 401(m)(6)), or certain amounts with- 
drawn from an IRA before the due date of the return (sec. 
408(d)(4)). 

Under the bill, the operation of community property laws is dis- 
regarded in determining the amount of aggregate annual distribu- 
tions subject to the excise tax. Thus, just as a nonemployee spouse's 
interest in an employee spouse's pension benefit is not taken into 
account in determining the taxable income of an employee upon 
distribution from or under a qualified plan, a nonemployee spouse's 
interest in such distributions is also disregarded in determining ag- 
gregate annual retirement distributions subject to the excise tax. 

c. Grandfather rule 

Present Law 

Under the Act, certain individuals may elect to be covered by a 
special grandfather rule that exempts from the excise tax benefits 
accrued as of August 1, 1986 (including benefits accrued under any 
arrangements distributions from which are subject to the tax). 
Under the grandfather, in the case of a defined contribution plan 
or IRA, the accrued benefit of a participant as of August 1, 1986, is 
the participant's accrued benefit on that date. In the case of a de- 



136 

fined benefit pension plan, the accrued benefit as of August 1, 1986, 
is the present value of the participant's benefit under the plan, de- 
termined as if the participant separated from service on that date. 
Benefits accrued as of August 1, 1986, to which the participant does 
not have a nonforfeitable right are included in the definition of ac- 
crued benefits for purposes of the grandfather rule. 

If the grandfather rule is elected, then, for all purposes, the 
threshold for retirement distributions that are excess distributions 
is $112,500 (indexed), rather than the greater of $112,500 (indexed) 
or $150,000. 

The election to use the grandfather rule is to be made on a 
return for a year beginning no later than January 1, 1988, and is 
to be made in such form and contain such information as the Sec- 
retary may prescribe. The election, once made, applies generally to 
all retirement distributions made with respect to an individual, in- 
cluding amounts subject to the special estate-level tax after the in- 
dividual's death. In addition, if an individual dies before the end of 
the election period, the executor of the individual's estate may 
make the grandfather election. 

The grandfather rule may only be elected with respect to an indi- 
vidual if, as of August 1, 1986, the present value of the individual's 
interests subject to the excess distribution tax (if such tax were in 
effect on that date) exceeds $562,500. 

Explanation of Provision 

Under the bill, for purposes of the grandfather rule, benefits ac- 
crued as of August 1, 1986, do not include amounts that, as of 
August 1, 1986, would not be distributions subject to the excise tax 
if distributed on that date. Thus, under the bill, an individual's ac- 
crued benefit, for purposes of the grandfather, does not include any 
portion of the accrued benefit that, as of August 1, 1986, (1) is pay- 
able to an alternate payee pursuant to a qualified domestic rela- 
tions order (sec. 414(p)) if includible in the income of the alternate 
payee, or (2) is attributable to the individual's investment in the 
contract. 

In addition, the bill clarifies that the grandfather rule is avail- 
able if amounts are received with respect to an individual under (1) 
the general rule, (2) the special rule for lump-sum distributions, or 
(3) the special estate tax. 

d. Post-death distributions 

Present Law 

The Act provided special rules to calculate the extent to which 
retirement distributions made with respect to an individual after 
the individual's death are excess distributions subject to the excise 
tax. In lieu of subjecting the post-death distributions (including dis- 
tributions of death benefits) to the annual tax on excess distribu- 
tions, the Act added an additional estate tax equal to 15 percent of 
the individual's excess retirement accumulation. After the estate 
tax is imposed, post-death distributions are disregarded entirely in 
applying the excise tax on excess distributions. Thus, beneficiaries 
who are receiving distributions (other than certain former spouses 



137 

receiving benefits pursuant to a qualified domestic relations order) 
are not required to aggregate those amounts with any other retire- 
ment distributions received on their behalf. 

The excess retirement accumulation is defined as the excess (if 
any) of the value of the decedent's interests in all qualified retire- 
ment plans, annuity plans, tax-sheltered annuities, and IRAs, over 
the present value of annual payments equal to the annual excess 
distribution ceiling for a period equal to the life expectancy of the 
individual immediately before death. 

In calculating the amount of the excess retirement accumulation, 
the value of the decedent's interest in all qualified plans, tax-shel- 
tered annuities, and IRAs will be taken into account regardless of 
the number of beneficiaries. 

Explanation of Provision 

The bill clarifies that, as is the case under the general rule, the 
amount of the excess retirement accumulation with respect to an 
individual for purposes of the special estate tax is determined with- 
out regard to community property laws. This rule is provided so 
that the treatment of post-death distributions is consistent with the 
treatment of distributions made with respect to an individual prior 
to death. 

In addition, under the bill, benefits that represent the decedent's 
investment in the contract or amounts payable to an alternate 
payee and includible in the alternate payee's income are disregard- 
ed in determining the excess retirement accumulation. 

The bill redefines the excess retirement accumulation to be the 
excess (if any) of the present value of the decedent's interests in all 
qualified retirement plans, annuity plans, tax-sheltered annuities, 
and IRAs, over the present value (as determined under rules pre- 
scribed by the Secretary as of the applicable valuation date) of a 
single life annuity with annual payments equal to the annual 
excess distribution limit (as in effect for the year in which death 
occurs and as if the individual had not died). 

Under the bill, the amount of excess retirement accumulations 
with respect to an individual does not include amounts that are 
death benefits payable with respect to such individual. Therefore, 
the bill provides that the amount of excess retirement accumula- 
tions does not include the value of any death benefits payable by 
the plan immediately after death with respect to a decedent to the 
extent that the sum of such death benefits plus other benefits pay- 
able with respect to the decedent exceeds the total value of benefits 
payable with respect to the decedent immediately prior to death. 

The bill clarifies that, with respect to this special estate-level tax, 
the tax may not be offset by any credits against the estate tax 
(such as the unified credit). 

Further, the bill provides an exception to the general rule that 
the special estate-level tax applies to all excess retirement accumu- 
lations with respect to an individual and that, after the estate-level 
tax is imposed, a beneficiary receiving distributions with respect to 
the individual is not required to aggregate the amounts received 
with any other retirement distributions received by the beneficiary 
on the beneficiary's own behalf. Under this exception, if the spouse 



138 

of an individual is the beneficiary of all retirement accumulations 
with respect to the individual, the spouse may elect, on a form at- 
tached to the estate tax return, (1) not to have the special estate- 
level tax apply and (2) for purposes of the general rule, to have the 
distributions received with respect to the individual aggregated 
with any distributions that the spouse receives on the spouse's own 
behalf. Thus, the amounts received with respect to the individual 
would be subject to the general excise tax on excess distributions to 
the extent that the amounts, when aggregated with the spouse's 
own benefits from or under qualified plans, tax-sheltered annuities, 
and IRAs, exceed the threshold for the excise tax. 

For purposes of this exception to the estate-level tax, if 1 or more 
persons other than the spouse are beneficiaries of a de minimis 
portion of the interests with respect to the individual that other- 
wise would be subject to the estate-level tax, then the spouse is not 
treated as failing to receive all excess retirement accumulations 
with respect to the individual. Further, such de minimis amounts 
are not subject to the excise tax on excess distributions nor to the 
special estate-level tax if the spouse makes the election described 
above. For purposes of this rule, an amount will not be considered 
de minimis if it exceeds 1 percent of the decedent's retirement ac- 
cumulation. 

e. Effective date 

Present Law 

Under the Act, the provisions generally apply to distributions 
made after December 31, 1986. The special estate-level tax applies 
with respect to the estate of a decedent dying after December 31, 
1986. 

Explanation of Provision 

The bill clarifies that the provisions do not apply to distributions 
with respect to a decedent who dies before January 1, 1987. 



E. Miscellaneous Pension and Deferred Compensation Provisions 

1, Discretionary contribution plans (sec. lllA(j) of the bill, sec. 

1136 of the Reform Act, and sees. 401(a) (27), 404, and 818 of 
the Code) 

Present Law 

Under present law, employer contributions to a profit-sharing 
plan are not limited to the employer's current or accumulated prof- 
its. Contributions to a money purchase pension plan are required 
to be fixed without reference to profits. 

Explanation of Provision 

Under the bill, a trust forming part of a plan will not be quali- 
fied unless the plan designates (at such time and in such manner 
as the Secretary may prescribe) whether the plan is intended to be 
a money purchase pension plan or a profit-sharing plan. Of course, 
a plan amendment is not required to comply with this rule until 
such time as plan amendments generally are required under the 
Act (sec. 1140). 

2. Time required for plan amendments (sec. lllA(l) of the bill and 

sec. 1140 of the Reform Act) 

Present Law 

The Act generally allowed plans that operated in compliance 
with the new requirements of Title XI of the Act to delay the cor- 
responding plan amendments to a specified time. 

Explanation of Provision 

The bill provides the same delayed amendment rules with re- 
spect to the plan amendments required by Title XVIII of the Act 
(the technical corrections title) or by the bill itself. This furthers 
the intent of Congress to ease the administrative burdens on plans 
by delaying the date required for certain amendments so that, in 
general, all required amendments can be made in a single year. 

In addition, the bill provides that a collective bargaining agree- 
ment is not to be treated as terminated merely because a plan is 
amended pursuant to the agreement to meet the requirements of 
Title XI or Title XVIII of the Act. The bill does not intend to create 
an inference that such an amendment otherwise would be consid- 
ered a termination, or that an amendment made solely to conform 
a plan to a requirement added by another Act is considered a ter- 
mination. 



(139) 



140 

3. Federal Thrift Savings Plan (sec. lllA(n) of the bill, sec. 1147 

of the Reform Act, and sees. 3121(v) and 7701(j) of the Code) 

Present Law 

Beginning in 1987, an employee generally is permitted to contrib- 
ute up to 10 percent of the employee's rate of basic pay to the 
Thrift Savings Plan maintained by the Federal Government. If spe- 
cial nondiscrimination requirements are satisfied and the limita- 
tion on elective deferrals is not exceeded, contributions to the plan 
are not treated as made available merely because the employee 
had an election to receive the amounts in cash. Therefore, the 
amounts deferred are not includible in an employee's income until 
distributed. 

Explanation of Provision 

The bill clarifies that the Thrift Savings Plan is required to meet 
the rules of section 401(k)(4)(B) under which the Plan may not be 
maintained by any State or local government or any tax-exempt or- 
ganization. 

In addition, under the bill, the Thrift Savings Fund may elect to 
have the nondiscrimination requirements applied separately to con- 
tributions to the Fund with respect to employees who are covered 
by the Civil Service Retirement and Disability System (CSRS) and 
thus are treated differently under the Thrift Savings Plan (e.g., 
with respect to matching contributions). Separate treatment under 
the nondiscrimination rules is analogous to the rules applicable to 
qualified plans maintained by employers other than the Federal 
Government. 

4. Effective dates for collectively bargained plans (sees. 111(c), (g), 

(h), and (n), and lllA(e) of the bill, and sees. 1105, 1111, 1112, 
1120, and 1131 of the Reform Act) 

Present Law 

Under the Act, the effective dates of certain provisions are de- 
layed with respect to plans maintained pursuant to 1 or more col- 
lective bargaining agreements between employee representatives 
and 1 or more employers ratified before March 1, 1986 ("collective- 
ly bargained plans"). In some cases, the delayed effective date ap- 
plies to the entire plan and, in other cases, the delay only applies 
to, for example, individuals covered by 1 or more of the collective 
bargaining agreements. 

The provisions subject to the delayed effective date generally do 
not apply to years beginning before the earlier of — 

(1) the later of (a) January 1, 1989 (or, in certain cases, Janu- 
ary 1, 1987) or (b) the date on which the last of the collective 
bargaining agreements terminates (determined without regard 
to any extension thereof after February 28, 1986), or 

(2) January 1, 1991 (or, in certain cases, January 1, 1989). 



141 
Explanation of Provision 

The bill generally provides that the delayed effective date with 
respect to collectively bargained plans applies to the entire plan in 
the case of the amendments made by section 1111 (relating to the 
application of nondiscrimination rules to integrated plans) and 
1112 (relating to the minimum coverage and participation require- 
ments for qualified plans) of the Act. As under present law, this 
delayed effective date does not apply to any noncoUectively bar- 
gained plans even if such plans have terms identical to those of a 
collectively bargained plan. 

Also, the bill modifies the delayed effective date with respect to 
the amendments made by section 1105, relating to the $7,000 limit 
on elective deferrals. Under present law, the $7,000 limit does not 
apply to contributions under a collectively bargained plan made 
pursuant to 1 or more of the collective bargaining agreements re- 
lating to the plan for taxable years beginning before the earlier 
of— 

(1) The date on which the last of such collective bargaining 
agreements terminates (determined without regard to any ex- 
tension thereof after February 28, 1986), or 

(2) January 1, 1991. 

Under the bill, clause "(D" above is modified to refer to the date 
on which the collective bargaining agreement pursuant to which 
the contribution is being made terminates. This change is appropri- 
ate because the $7,000 limit is applied at the individual taxpayer 
level. Thus, the later termination of a collective bargaining agree- 
ment to which an individual is not subject should not affect that 
individual's tax treatment. 

The bill also provides a delayed effective date for collectively bar- 
gained plans with respect to 2 additional sections of the Act. First, 
the amendments made by section 1120, applying nondiscrimination 
rules to tax-sheltered annuity programs (sec. 403(b)), are not to 
apply to collectively bargained plans in plan years beginning before 

4-l-|£i f*f5T*ll^T* Or 

(1) the later of (a) January 1, 1989, or (b) the date on which 
the last of the collective bargaining agreements terminates 
(without regard to any extension thereof after February 28, 
1986), or 

(2) January 1, 1991. 

This delayed effective date applies to the entire program. 

In addition, the amendments made by section 1131, relating to 
the limits on deductions for contributions under a qualified plan 
and to the excise tax on nondeductible contributions under a quali- 
fied plan, are not to apply to contributions under a collectively bar- 
gained plan made pursuant to any of the collective bargaining 
agreements relating to the plan for taxable years beginning before 
the earlier of — 

(1) January 1, 1989, or 

(2) the date on which the last of the collective bargaining 
agreements terminates (determined without regard to any ex- 
tension thereof after February 28, 1986). 



F. Employee Benefit Provisions 

1. Nondiscrimination rules for statutory employee benefit plans 
(sec. lllB(a) of the bill, sec. 1151 of the Reform Act, sec. 209 
of the Social Security Act, and sees. 89, 125, 129, 414, 3121, 
3231, 3306, 3401, and 6652 of the Code) 

In general 

Under present law, new nondiscrimination rules apply to statuto- 
ry employee benefit plans (sec. 89). The term "statutory employee 
benefit plans" includes accident or health plans and group-term 
life insurance plans. At the election of the employer, the term also 
includes qualified group legal services plans, educational assistance 
programs, and dependent care assistance programs. 

Under the new nondiscrimination rules, a plan generally is re- 
quired to satisfy 3 eligibility tests — a 50-percent test, a 90-percent/ 
50-percent test, and a nondiscriminatory provision test — and a ben- 
efits test. Alternatively, a plan may satisfy an 80-percent coverage 
test, provided it also satisfies the nondiscriminatory provision test. 

Nondiscrimination tests 

50-percent test 

Under the 50-percent test, nonhighly compensated employees 
must constitute at least 50 percent of the group of employees eligi- 
ble to participate in the plan. This requirement will be deemed sat- 
isfied if the percentage of highly compensated employees who are 
eligible to participate is not greater than the percentage of non- 
highly compensated employees who are eligible. 

90-percent/ 50-percent test 

A plan does not satisfy the 90-percent/ 50-percent test unless at 
least 90 percent of the employer's nonhighly compensated employ- 
ees are eligible for a benefit that is at least 50 percent as valuable 
as the benefit available to the highly compensated employee to 
whom the most valuable benefit is available. For purposes of this 
test, all plans of the same type (i.e., all benefits excludable under 
the same Code section) are aggregated. 

For purposes of this 90-percent/ 50-percent test, available salary 
reduction is not taken into account. 

Nondiscriminatory provision test 

The third eligibility test provides that a plan may not contain 
any provision relating to eligibility to participate that by its terms 
or otherwise discriminates in favor of highly compensated employ- 
ees. This third test is intended to disqualify arrangements only on 
the basis of discrimination that is not quantifiable. 

(142) 



143 

Benefits test 

A plan does not satisfy the benefits test unless the average em- 
ployer-provided benefit received by nonhighly compensated employ- 
ees under all plans of the employer of the same type (i.e., plans 
providing benefits excludable under the same Code section) is at 
least 75 percent of the average employer-provided benefit received 
by highly compensated employees under all plans of the employer 
of the same type. 

Alternative test 

Present law also provides an alternative test that may be applied 
in lieu of the eligibility and benefits tests described above. If a plan 
benefits at least 80 percent of an employer's nonhighly compensat- 
ed employees, such plan is considered to satisfy the new nondis- 
crimination rules. This alternative test will not apply unless the 
plan satisfies the nondiscriminatory provision test described above. 

This alternative test applies only to accident or health plans and 
group-term life insurance plans. For purposes of this alternative 
test, an individual will only be considered to benefit under a plan if 
such individual receives coverage under the plan; eligibility to re- 
ceive coverage is not considered benefiting under the plan. 

Valuation 

The Secretary is to prescribe rules regarding valuation of differ- 
ent benefits. With respect to health coverage, the Secretary is to 
prescribe tables prescribing the relative values of different types of 
health coverage. 

Definitions 

For purposes of applying the new nondiscrimination rules, 
present law provides generally applicable definitions of the follow- 
ing: (1) highly compensated employee (sec. 414(q)); (2) employer (in- 
cluding the employee leasing rules (sec. 414 (b), (c), (m), (n), (o), and 
(t))); (3) line of business or operating unit (as present law permits 
the new nondiscrimination rules to be applied separately to sepa- 
rate lines of business or operating units (sec. 414(r))); and (4) em- 
ployees who are excluded from consideration. These definitions, 
other than the line of business or operating unit rule, apply gener- 
ally to all employee benefit plans, not only to statutory employee 
benefit plans. 

Qualification and reporting requirements 

Employee benefit plans generally are subject to new qualification 
and reporting requirements (sec. 89(k) and (1)). 

a. Employers with no nonhighly compensated employees 
Present Law 

Under present law, the nondiscrimination rules applicable to 
statutory employee benefit plans are applied by reference to the 
eligibility of nonhighly compensated employees to participate in a 
plan or to the amount of benefits provided to nonhighly compensat- 
ed employees under a plan. It is unclear under present law how 



144 

these nondiscrimination rules apply in the case of an employer 
who has no nonhighly compensated employees. 

Explanation of Provision 

The bill clarifies that the nondiscrimination rules do not apply to 
an employer in a year in which such employer has no nonhighly 
compensated employees. As is so with respect to the nondiscrimina- 
tion rules generally, this rule is to apply separately with respect to 
former employees under rules prescribed by the Secretary. 

b. Plan aggregation 

Present Law 

Under present law, each different option generally is a separate 
plan for testing purposes. However, for purposes of the 50-percent 
eligibility test and the 80-percent alternative test, comparable acci- 
dent or health plans may be aggregated (sec. 89(g)(1)). 

Explanation of Provision 

The bill provides that, under rules prescribed by the Secretary, if 
an employee is eligible for (in the case of the 50-percent test) or re- 
ceives coverage under more than 1 accident or health plan, then, 
for purposes of the 50-percent test and the alternative 80-percent 
test, such plans are required to be considered 1 plan with respect to 
such employee. 

For example, assume that an employer maintains 2 plans: 1 ben- 
efiting all employees with a value of $950 and a second benefiting 
only highly compensated employees with a value of $1,000. The 
highly compensated employees receiving benefits from both plans 
are to be treated for purposes of the 50-percent test and the alter- 
native 80-percent test as receiving $1,950 of benefits from 1 plan 
while the nonhighly compensated employees are to be treated as 
receiving $950 of benefits from a separate plan. Under the compa- 
rability rules (sec. 89(g)(1)), these plans would not be comparable so 
that the plan covering the highly compensated employees would 
satisfy neither the 50-percent test nor the alternative 80-percent 
test. 

c. Family coverage 

Present Law 

Under present law, a special rule applies in the case of family 
coverage under an accident or health plan. Pursuant to this special 
rule, the coverage for employees and the coverage for spouses and 
dependents may be tested separately, as if they constituted 2 differ- 
ent types of plans, for purposes of the 90-percent/ 50-percent test. 
Further, for purposes of the same test, with respect to coverage of 
spouses and dependents, the employer may disregard employees 
who do not have a spouse or dependent. An employer who elects 
this latter optional rule is required to obtain and maintain, in such 
manner as the Secretary prescribes, adequate sworn statements to 
demonstrate whether employees have a spouse or dependent. 



145 

Explanation of Provision 

The bill deletes the rule allowing employers to apply the 90-per- 
cent/ 50-percent test separately with respect to family coverage and 
to take into account for such purpose only employees who have a 
family. This rule implies that family coverage cannot be considered 
available to an employee who does not have a family. 

Under the bill, family coverage (i.e., coverage of an employee's 
family which is considered separate from coverage of the employee) 
may be considered to be available or provided to an employee de- 
spite the fact that the employee does not have a family. The pur- 
pose of this rule is to relieve employers from the burden of deter- 
mining which employees have families. 

This rule alone, however, could produce inappropriate results in 
certain very limited circumstances and it is intended that the non- 
discriminatory provision test be applied to prevent such results. 
Thus, if, under the facts and circumstances, it is clear that the em- 
ployer is, by using the above rule that allows family coverage to be 
considered to be available or provided to an employee who does not 
have a family, evading the other nondiscrimination tests, the non- 
discriminatory provision test is not to be considered satisfied with 
respect to the relevant plan or plans. 

For example, assume that an employer had 2 highly compensat- 
ed employees and 8 nonhighly compensated employees, none of 
whom had families. The employer provided $3,000 of employee cov- 
erage to each of the 2 highly compensated employees. For the same 
year, the employer provided family coverage to each of the 8 non- 
highly compensated employees the value of which was $3,000 per 
employee under the Secretary's valuation tables. Because compara- 
ble plans may be aggregated for purposes of the alternative 80-per- 
cent test, the employer would satisfy such test. This is not the 
result intended by Congress, since the facts of this example clearly 
indicate that by using the rule allowing family coverage to be con- 
sidered to be provided to employees without families, the employer 
is avoiding providing the nonhighly compensated employees truly 
nondiscriminatory benefits. Thus, the nondiscriminatory provision 
test would not be considered satisfied with respect to the plan cov- 
ering the highly compensated employees. 

This application of the nondiscriminatory provision test applies 
not only with respect to evasion of the alternative 80-percent test, 
but to evasion of any of the tests. For example, the nondiscrimina- 
tory provision test would not be considered satisfied with respect to 
a plan maintained by the employer in the above example for its 
highly compensated employees if such plan satisfied the 90-per- 
cent/ 50-percent test by virtue of a second plan making family cov- 
erage available to the nonhighly compensated employees. 

d. Sworn statements 

Present Law 

For purposes of applying the benefits test to accident or health 
plans, an employer generally (see sec. 89(g)(2)(D)) may elect to disre- 
gard any employee or family member of an employee if such indi- 
vidual is covered by a health plan that provides core benefits and 



73-917 0-87-6 



146 

that is maintained by another employer of the employee or of a 
member of the employee's family. An employer who elects this op- 
tional rule is required to obtain and maintain, in such manner as 
the Secretary prescribes, adequate sworn statements to demon- 
strate whether individuals have core health coverage from another 
employer. 

Explanation of Provision 

The WU provides that, with respect to an employer ("first em- 
ployer"), an individual may be considered to have core health bene- 
fits from another employer of such individual or of a member of 
such individual's family, despite the fact that no sworn statement 
is obtained and maintained to that effect, if (1) the first employer 
makes available to an employee, at no cost, core health benefits 
with respect to such individual, and (2) no health benefits under 
any plan of the first employer are provided with respect to such 
individual. For purposes of this rule, any financial detriment with 
respect to core health benefits, regardless of whether it is direct or 
indirect, current or future, fixed or contingent, is considered a cost 
rendering this special rule inapplicable. A benefit that is available 
to an employee on the condition that such employee reduce his 
salary or forego another benefit is considered available at a cost. 

Under present law, with respect to an employer that elects to 
disregard individuals covered (or deemed covered under the rule 
described above) by another employer's core health benefits, in the 
absence of a sworn statement, a highly compensated employee is 
treated as (1) covered by a plan of another employer providing core 
health benefits, and (2) not having a spouse or dependent. Thus, 
the special rule under the bill described above only affects non- 
highly compensated employees. 

e. Excluded employees 

Present Law 

Under present law, certain classes of employees are disregarded 
in applying the nondiscrimination rules if neither the plan, nor 
any other plan of the same type, is available to any employee in 
the same class. Two of the disregarded classes are (1) in the case of 
an accident or health plan (other than with respect to noncore ben- 
efits), employees who have not completed 6 months of service (or 
such shorter period of service as may be specified in the plan); and 
(2) in the case of any other statutory employee benefit plan (includ- 
ing an accident or health plan with respect to noncore benefits), 
employees who have not completed 1 year of service (or such short- 
er period of service as may be specified in the plan). 

An employer is to exclude an employee, on the grounds that such 
employee has not satisfied the required period of initial service, 
during the period prior to the first day of the calendar month im- 
mediately following the actual satisfaction of the initial service re- 
quirement. In general, this exclusion does not apply if any employ- 
ee is eligible under any plan of the same type prior to the first day 
of the calendar month immediately following the actual satisfac- 
tion of the initial service requirement. 



147 

In addition, the legislative history of the Act provided certain 
rules of convenience, relating to the time at which the nondiscrim- 
ination rules are to be applied, that were intended to reduce the 
administrative burden of applying the nondiscrimination rules. 

Explanation of Provision 

Under the bill, the rule regarding the exclusion of employees be- 
tween the date of actual satisfaction of the initial service require- 
ment and the first day of the calendar month immediately follow- 
ing such satisfaction is modified so that an employer may use, in- 
stead of the first day of the next calendar month, the first day of a 
period of less than 31 days specified by the plan. For example, 
assume that an employer required 60 days of service for participa- 
tion in a health plan, but did not allow participation to commence 
other than on the first day of 4-week periods. Such employer is to 
exclude employees during the period prior to the first day of the 4- 
week period following satisfaction of the 60-days-of-service require- 
ment. 

The Secretary is to provide corresponding changes to the rules of 
convenience relating to the time for testing described in the legisla- 
tive history of the Act. 

This amendment, allowing use of a period of less than 31 days, 
provides employers with flexibility without adversely affecting the 
policy of the nondiscrimination rules. 

f. Self-employed individuals 

Present Law 

Under the Act, it is unclear whether self-employed individuals 
are treated as employees for purposes of the nondiscrimination 
rules applicable to statutory employee benefit plans. 

Explanation of Provision 

The bill clarifies that, for purposes of applying the nondiscrim- 
ination rules to statutory employee benefit plans, the term "em- 
ployee" includes any self-employed individual (as defined in sec. 
401(c)(1)), and the term "compensation" includes such individual's 
earned income (as defined in sec. 401(c)(2)). 

In addition, an individual who owns the entire interest in an un- 
incorporated trade or business is to be treated as his own employer. 
A partnership is to be treated as the employer of each partner who 
is treated as an employee under the rule described above. 

These rules do not affect whether a self-employed individual may 
exclude a benefit provided under a statutory employee benefit plan. 
For example, group-term life insurance provided to a self-employed 
individual may not be excluded by the self-employed individual be- 
cause section 79 does not apply to self-employed individuals. The 
effect of this provision of the bill is to count a self-employed indi- 
vidual as an employee even though such individual is not eligible 
for the exclusion. Generally, this will facilitate compliance with the 
nondiscrimination rules, since self-employed individuals, who gen- 
erally are highly compensated employees under the applicable defi- 
nition (sec. 414(q)), are taken into account but treated only as eligi- 



148 

ble for and receiving benefits that are excludable or deductible. 
Thus, for example, with respect to health benefits, a self-employed 
individual is treated as receiving (or eligible for) a benefit equal to 
25 percent of the amount paid (or payable) for health insurance, 
since that is the only amount that is tax-favored with respect to a 
self-employed individual (sees. 106 and 162(m)). 

g. Sanctions 

Present Law 

Year of inclusion 

Under present law, if a plan is discriminatory in a plan year, 
highly compensated employees are taxable on the value of the dis- 
criminatory excess in their taxable year in which or with which 
the plan year ends. 

Discriminatory excess 

The discriminatory excess is defined as the amount of the other- 
wise nontaxable employer-provided benefit (including benefits pur- 
chased with elective contributions) that would have to have been 
purchased with after-tax employee contributions by the highly 
compensated employees in order for all of the nondiscrimination 
tests to be satisfied. In the case of group-term life insurance, the 
value of discriminatory coverage is the greater of the cost of cover- 
age under section 79(c) or the actual cost of coverage. 

Employer sanction 

If the employer does not report the discriminatory excess (or 
other amounts includible under sec. 89) in a timely manner, the 
employer may be subject to an employer-level sanction (sec. 
6652(1)). 

Explanation of Provision 
Year of inclusion 

Under present law, if a plan is discriminatory and the plan year 
is, for example, the calendar year, the employer has only 1 month 
to determine the discriminatory excess with respect to the highly 
compensated employees in order to file accurate Forms W-2 in a 
timely manner. In many cases, this is not a sufficient period of 
time. Thus, the bill provides a special rule with respect to plans 
with a plan year ending after September 30 and on or before De- 
cember 31 of a calendar year. 

Under this special rule, an employer may elect to have the dis- 
criminatory excess included in the incomes of highly compensated 
employees in their taxable year following the taxable year with or 
within which the plan year ends. If an employer makes such an 
election, however, the employer's deduction relating to such dis- 
criminatory excess is to be allowable only in the employer's taxable 
year with or within which ends the plan year following the plan 
year in which the discriminatory excess occurred. It is not intend- 
ed, however, that an employer be permitted to avoid the deferral of 



149 

the deduction through the use of a short plan year following the 
plan year in which the discriminatory excess occurred. 

Discriminatory excess 

For purposes of determining and allocating the discriminatory 
excess with respect to a group-term life insurance plan, employer- 
provided coverage over $50,000 will be treated as nontaxable under 
the bill. Thus, to the extent that the discriminatory coverage does 
not exceed the total coverage over $50,000, the effect of a finding of 
discrimination is simply the inclusion in income of the excess, if 
any, of the actual cost of the discriminatory coverage over the cost 
of such coverage under section 79(c). 

For example, assume an employee receives $150,000 of employer- 
provided coverage and the $100,000 excess over $50,000 is included 
in income, at the cost determined under section 79(c), pursuant to 
section 79(a). Assume further that $25,000 of such employee's cover- 
age is determined to be discriminatory. The effect of this finding of 
discrimination is that the excess, if any, of the actual cost of such 
$25,000 of coverage over the section 79(c) cost of such coverage is 
included in the employee's income (in addition to the section 79(c) 
cost of the $100,000 of coverage (i.e., the amount over $50,000)). 

Qualification rule 

If a plan to which section 505 applies — generally, a plan part of 
which is a voluntary employees' beneficiary association (VEBA) 
(sec. 501(c)(9)) or a qualified group legal services organizations 
(GLSO) (sec. 501(c)(20)) — violates the new qualification require- 
ments (sec. 89(k)), the VEBA or GLSO is not to be exempt from tax 
under section 501(a). A plan failing to satisfy the new qualification 
requirements is not the type of plan for which the VEBA or GLSO 
tax exemption was established. 

Employer sanction 

If an employer does not report a discriminatory excess (or other 
amount includible under sec. 89) in a timely manner, the employer 
may be subject to an employer-level sanction. Under the bill, it is 
clarified that the employer-provided benefit subject to the employer 
sanction is determined under the general rules applicable under 
section 89 except that the special rule relating to group-term life 
insurance plans, under which employees are assumed to be age 40, 
does not apply. Of course, the adjustment of the employer-provided 
benefit under a group-term life insurance plan based on the em- 
ployee's compensation also does not apply. 

h. Inclusion in wages 

Present Law 

Under present law, amounts that are includible in an employee's 
income because the section 89 requirements relating to employee 
benefit plans are not satisfied are not in all cases treated as wages 
(or compensation) for employment tax purposes. 



150 

Explanation of Provision 

Under the bill, amounts that are includible in gross income by 
reason of section 89 are included in wages (or compensation), as of 
the time includible in gross income, for purposes of the Federal In- 
surance Contributions Act (sec. 3121), the Railroad Retirement Tax 
Act (sec. 3231(e)), the Federal Unemployment Tax Act (sec. 3306), 
income tax withholding (sec. 3401), and the Social Security Act (sec. 
209). Of course, such inclusion is subject to the applicable limits on 
wages (or compensation). 

i. Dependent care assistance programs 
Present Law 

Present law provides a benefits test applicable to dependent care 
assistance programs that are not treated as statutory employee 
benefit plans under section 89 (sec. 129(d)(8)). For purposes of apply- 
ing this benefits test to salary reduction amounts, employees with 
compensation (as defined in sec. 414(q)(7)) below $25,000 are to be 
disregarded. This special rule does not apply if the dependent care 
assistance program is treated as a statutory employee benefit plan 
under section 89. 

Explanation of Provision 

For purposes of applying the special benefits test (sec. 129(d)(7), 
as redesignated by the bill) to salary reduction amounts under a 
dependent care assistance program that is not treated as a statuto- 
ry employee benefit plan under section 89, an employer may elect 
to take into account employees with compensation (as defined in 
sec. 414(q)(7)) below $25,000. Thus, the employer may elect to take 
into account all employees with compensation below $25,000 or 
may disregard employees with compensation below any specified 
amount lower than $25,000. This rule is provided so that an em- 
ployer may elect to take into account all nonhighly compensated 
employees in applying the special benefits test. 

j. Cafeteria plans 

Present Law 

Definition of a cafeteria plan 

Under present law, the definition of a cafeteria plan includes a 
plan only offering a choice between nontaxable benefits (sec. 125). 

Qualified benefits 

To qualify as a cafeteria plan, a plan may not offer benefits other 
than cash and qualified benefits. The term "qualified benefits" gen- 
erally means any benefit that, with the application of section 
125(a), is excludable from an employee's income by reason of a pro- 
vision of Chapter 1 of the Code (other than sees. 117, 124, 127, or 
132). In addition, the term includes (1) any group-term life insur- 
ance coverage that is includible in income only because it is in 
excess of $50,000, and (2) any other benefit permitted under regula- 
tions. 



151 

Explanation of Provision 

Definition of a cafeteria plan 

The bill amends the definition of a cafeteria plan so that a choice 
between nontaxable benefits is not a cafeteria plan. The inclusion 
of a choice between nontaxable benefits as a cafeteria plan would 
require, to make the provision effective as a practical matter, addi- 
tional amendments not intended by Congress. For example, under 
present law, a choice between nontaxable benefits, one of which 
constituted deferred compensation, would generally not be a cafete- 
ria plan in light of the prohibition on deferred compensation in a 
cafeteria plan. Thus, an employer could simply add to any choice 
between nontaxable current benefits the choice of a nominal non- 
taxable deferred benefit; this would at least arguably remove the 
arrangement from the definition of a cafeteria plan. Although this 
and other problems with the new definition could have been indi- 
vidually addressed with additional rules, such rules would have 
added complexity not contemplated by Congress. 

Sanctions 

The bill also clarifies that, in the case of a cafeteria plan that 
fails the cafeteria plan nondiscrimination test (sec. 125(b)(1)), only 
highly compensated employees are taxable on the available taxable 
benefits. In the case of a cafeteria plan that fails the key employee 
concentration test (sec. 125(b)(2)), the bill clarifies that only key em- 
ployees are taxable on the available taxable benefits. 

Qualified benefits 

In addition, the bill modifies the definition of qualified benefits. 
Under the bill, the term "qualified benefits" includes benefits that 
would be qualified benefits but for the fact that they are includible 
in an employee's income under section 89. Thus, if, for example, 
there is a discriminatory excess with respect to a health plan of- 
fered under a cafeteria plan, such discriminatory excess will not 
cause the cafeteria plan to cease to be a cafeteria plan. 

k. Continuation of health care 

Present Law 

Under present law, for purposes of most employee benefit provi- 
sions, certain aggregation rules are applied (sec. 414(b), (c), (m), (o), 
and (t)). Thus, related employers generally are treated as a single 
employer for purposes of these provisions. Further, under certain 
circumstances, leased employees may be treated as employees of 
the lessee (sec. 414(n)). 

Explanation of Provision 

The bill extends the rules aggregating related employers (sec. 
414(b), (c), (m), (o), and (t)) and the employee leasing rules (sec. 
414(n)) to the continuation-of-health-care rules under section 
162(i)(2) and 162(k) and under section 2201(b) of the Public Health 
Service Act. (The Act applied such aggregation and leasing rules 
for purposes of the continuation-of-health-care rules under sec. 106 



152 

and the Employment Retirement Income Security Act of 1974 
(ERISA).) Such extension presents evasion of the continuation-of- 
health-care rules by the use of multiple employers, employee leas- 
ing, or other arrangements. 

Under the bill, this extension and the application under the Act 
of the same aggregation and leasing rules to section 106 (relating to 
the exclusion from income of employer-provided accident or health 
coverage) and to the continuation-of-health-care rules of ERISA are 
effective for years beginning after 1986. 

1. Effective date 

Present Law 

In general, the amendments made by section 1151 of the Act, 
which provide the new rules regarding nondiscrimination, depend- 
ent care assistance programs, cafeteria plans, qualification, and re- 
porting generally are effective for years beginning after the later 
of— 

(1) December 31, 1987, or 

(2) the earlier of — 

(a) the date that is 3 months after the date on which the Sec- 
retary issues regulations under section 89, or 

(b) December 31, 1988. 

Explanation of Provision 

Under the bill, an employer may elect to apply the new rules of 
section 1151 of the Act (including the nondiscrimination rules, 
qualification rules, reporting rules, and cafeteria plan rules) to cer- 
tain group-term life insurance plans in plan years beginning after 
October 22, 1986. The plans for which this election is available are 
described in section 125(c)(2)(C). 

2. Deductibility of health insurance costs of self-employed individ- 
uals (sec. lllB(b) of the bill, sec. 1161 of the Reform Act, and 
sec. 162(m) of the Code) 

Present Law 

Under certain circumstances, a self-employed individual may 
deduct 25 percent of the amounts paid for health insurance for a 
taxable year on behalf of the individual and the individual's spouse 
and dependents (sec. 162(m)). The deduction is allowable in calcu- 
lating adjusted gross income. 

Explanation of Provision 

The bill clarifies that, consistent with the Congressional intent 
reflected in the Statement of Managers, the amount deductible 
under section 162(m) is not taken into account in computing net 
earnings from self-employment (sec. 1402(a)). Therefore, the 
amounts deductible under section 162(m) do not reduce the income 
base for the self-employed individual's social security tax. 



■^ 



153 

3 Treatment of certain full-time life insurance salespersons (sec. 
lllB(e) of the bill, sec. 1166 of the Reform Act, and sec. 
7701(a)(20) of the Code) 

Present Law 

Under present law, a full-time life insurance salesperson is treat- 
ed as an employee for purposes of the cafeteria plan provision with 
respect to accident and health plans. 

Explanation of Provision 

The bill clarifies Congressional intent, reflected in the Statement 
of Managers, to treat full-time life insurance salespersons as em- 
ployees for purposes of the cafeteria plan provision with respect to 
benefits that the salesperson is otherwise permitted to exclude 
from income. 

4. Exclusion of cafeteria plan elective contributions from wages 
for purposes of employment taxes (sec. lllB(a) of the bill, sec. 
1151(d) of the Reform Act, sec. 209(e) of the Social Security Act, 
and sees. 3121(a)(5) and 3306(b)(5) of the Code) 

Present Law 

Under present law, no amount is included in the gross income of 
a participant in a cafeteria plan meeting certain requirements 
solely because, under the plan, the participant may choose among 
the benefits of the plan. Under the Act, this exception from the 
principles of constructive receipt generally also applies for pur- 
poses of FICA and FUTA taxes. The exception does not apply, how- 
ever, for FICA and FUTA tax purposes with respect to elective de- 
ferrals under a qualified cash or deferred arrangement that is part 
of a cafeteria plan. 

Explanation of Provision 

The bill clarifies that the exclusion from wages provided under 
the Act with respect to FICA and FUTA taxes is limited to pay- 
ments under a cafeteria plan that are excludable from gross 
income and that would not be treated as wages if provided outside 
of the cafeteria plan. Thus, for example, no amount is included in 
an employee's wages for FICA and FUTA tax purposes attributable 
to the employee's election of a health benefit under a cafeteria 
plan if no amount is included in the employee's income with re- 
spect to such election. 

5. Tax treatment of qualified campus lodging (sec. lllB(d) of the 
bill, sec. 1164 of the Reform Act, and sec. 119(d) of the Code) 

Present Law 

Under present law, the fair market value of use (on an annua- 
lized basis) of qualified campus lodging furnished by, or on behalf 
of, an educational institution (within the meaning of sec. 
170(b)(l)(A)(ii)) is treated as not greater than 5 percent of the ap- 
praised value for the lodging, but only if an independent appraisal 



154 

of the fair market value of the lodging is obtained by a qualified 
appraiser under rules prescribed by the Secretary. For purposes of 
this rule, the appraised value is to be determined as of the close of 
the calendar year in which the taxable year begins. 

The purpose of this provision is to avoid disputes between educa- 
tional institutions and the Internal Revenue Service regarding 
whether an individual has income attributable to the use, for a 
specified rent, of employer-furnished lodging located on a campus 
of, or in the proximity of, the educational institution. 

Explanation of Provision 

If the appraised value of qualified campus lodging is determined 
as of the close of the calendar year in which the taxable year 
begins, the 5-percent ceiling on the value of use of such lodging 
may not be known until after the beginning of the rental period 
and thus after the rent for the lodging has been established. The 
result may be that the rent chosen is below the 5-percent ceiling, 
which may give rise to income for the individual using the lodging. 

The bill modifies the date on which the appraised value is deter- 
mined in the case of a rental period not greater than 1 year. In 
such case, the appraised value may be determined at any time 
during the calendar year in which the rental period begins. 

6. Military fringe benefits (sec. lllB(f) of the bill, sec. 1168 of the 
Reform Act, and sec. 134 of the Code) 

Present Law 

Under present law, qualified military benefits are excludable 
from gross income. The term "qualified military benefit" generally 
means any allowance or in-kind benefit that — 

(1) is received by any member or former member of the uni- 
formed services of the United States or any dependent of such 
member by reason of such member's status or service as a member 
of such uniformed services, and 

(2) was excludable from gross income on September 9, 1986, 
under any provision of law or regulation thereunder that was in 
effect on such date (other than a provision of Title 26). 

For purposes of the exclusion of qualified military benefits that 
are payable in cash, certain adjustments to such benefits after Sep- 
tember 9, 1986, are to be disregarded and thus are not to be cov- 
ered by the section 134 exclusion. 

Of course, benefits provided in connection with an individual's 
status or service as a member of the uniformed services may be ex- 
cluded from income under other sections of the Code if the require- 
ments for exclusion under such other sections are satisfied, even if 
such benefit does not qualify as a qualified military benefit. 

Explanation of Provision 

The bill clarifies that, with respect to the definition of qualified 
military benefit, the exclusion on September 9, 1986, may have 
been by administrative practice, in addition to by law or regula- 
tion. 



155 

The bill also provides that the term "qualified military benefit" 
does not include personal use of a vehicle. This amendment applies 
to taxable years beginning after December 31, 1986. 

Under the bill, it is further intended that qualified military bene- 
fits that are provided in kind may be modified or adjusted after 
September 9, 1986, without affecting the excludability of such bene- 
fit under section 134. 

In addition, the bill modifies the general effective date of section 
134 to apply to taxable years beginning after December 31, 1984 
(rather than beginning after December 31, 1986). 



G. Employee Stock Ownership Plans (ESOPs) 

An employee stock ownership plan (ESOP) is a qualified stock 
bonus plan or a combination of a stock bonus and a money pur- 
chase pension plan under which employer stock is held for the ben- 
efit of employees. The stock, which is held by 1 or more tax-exempt 
trusts under the plan, may be acquired through direct employer 
contributions or with the proceeds of a loan to the trust (or trusts) 
that is exempt under section 4975. An ESOP is required to be de- 
signed to be invested primarily in employer securities. 

1. Changes in qualincation requirements relating to ESOPs (sec. 
lllB(i), (j), and (k) of the bill, sees. 1174-1176 of the Reform 
Act, and sees. 401, 415, and 409 of the Code) 

a. Diversification of investments 
Present Law 

The Act requires an ESOP to offer a partial diversification elec- 
tion to participants who meet certain age and participation re- 
quirements (qualified participants). Under the Act, a qualified par- 
ticipant is entitled annually during any diversification election 
period following each plan year in the participant's qualified elec- 
tion period to direct diversification of up to 25 percent of the par- 
ticipant's account balance (50 percent in the last election period). 

Under the Act, an ESOP is required to provide an annual diver- 
sification election period for the 90-day period following the close of 
the ESOP plan year. Thus, for 90 days after the end of a plan year, 
an ESOP is to permit an election by those qualified participants 
who become or remain eligible to make a diversification election 
during the plan year. Under the Act, any participant who has at- 
tained at least age 55 and completed at least 10 years of participa- 
tion in the plan is a qualified participant. A qualified participant 
may modify, revoke, or make a new election at any time during the 
90-day election period. Any qualified participant is permitted to 
make a diversification election during each diversification election 
period following each plan year in the participant's qualified elec- 
tion period. 

No later than 90 days after the close of the election period, the 
plan is to complete diversification pursuant to participant elec- 
tions. The diversification requirement can be satisfied by (1) offer- 
ing to distribute to the participant an amount equal to the amount 
for which the participant elected diversification, (2) substituting for 
the amount of the employer securities for which the participant 
elected diversification an equivalent amount of other assets, in ac- 
cordance with the participant's investment direction, or (3) provid- 
ing the participant the option to transfer (in accordance with appli- 
cable qualification rules) the portion of the account balance for 

(156) 



157 

which diversification is elected into a qualified plan that provides 
for employee-directed investment and in which the required diver- 
sification options are available. The ESOP, or the transferee plan 
in the case of a transfer described in (3), is to offer at least 3 invest- 
ment options (not inconsistent with regulations prescribed by the 
Secretary). 

Explanation of Provision 

In order to conform to Congressional intent, the bill clarifies that 
a qualified participant's qualified election period generally begins 
with the plan year during which the participant attains age 55 and 
ends with the fifth succeeding plan year. If, however, the partici- 
pant has not completed 10 years of plan participation by the end of 
the plan year in which the participant attains age 55, the qualified 
election period begins with the plan year in which the participant 
completes 10 years of plan participation and ends with the fifth 
succeeding plan year. 

For example, in the case of an ESOP using the calendar year as 
the plan year, a participant who completes 10 years of plan partici- 
pation before attaining age 55 and who attains age 55 in 1990, be- 
comes a qualified participant in the plan year beginning January 1, 
1990. That participant is eligible to direct diversification during the 
90-day election period beginning January 1, 1991, and remains eli- 
gible to direct diversification during the annual election periods in 
1992, 1993, 1994, 1995, and 1996. 

Similarly, if the participant completes 10 years of participation 
in 1990 when the participant is 58, the participant becomes a quali- 
fied participant in the plan year beginning January 1, 1990. The 
participant is eligible to direct diversification during the election 
periods in 1991, 1992, 1993, 1994, 1995, and 1996. 

Under the bill, the qualified election period of any participant 
does not begin before the first plan year beginning after December 
31, 1986. Thus, for example, under the bill, if a participant in a cal- 
endar year ESOP attained age 55 and had 10 years of plan partici- 
pation in 1986, the participant is eligible to make a diversification 
election during the election periods in 1988, 1989, 1990, 1991, 1992, 
and 1993. 

The bill also clarifies that diversification is to be completed no 
later than 90 days after the close of the election period, regardless 
of the method used to implement diversification elections. Thus, di- 
versification is to be completed within the 90-day period regardless 
of whether diversification is implemented by means of distribution, 
transfer to another qualified plan which offers the requisite invest- 
ment options, or reinvestment of employer securities in other 
assets. 

b. Distributions from tax-credit ESOPs 
Present Law 

An ESOP under which an employer contributes employer securi- 
ties (or cash with which to acquire employer securities) in order to 
qualify for a credit against income tax liability is referred to as a 
tax-credit ESOP. This credit was initially investment-based (and 



158 

the plans were called TRASOPs due to their origin in the Tax Re- 
duction Act of 1975), but was payroll-based after 1982 (and the 
plans were called PAYSOPs). The Act repealed the credit with re- 
spect to compensation paid or accrued after December 31, 1986. 

Tax-credit ESOPs are subject to the requirements generally ap- 
plicable to qualified plans and ESOPs. In addition, tax-credit 
ESOPs are subject to special qualification requirements. In general, 
under present law, employer securities allocated to an employee's 
account under a tax-credit ESOP may not be distributed before the 
end of the 84th month after the month in which the securities were 
allocated. This limitation does not apply to distributions of securi- 
ties in the case of the employee's separation from service death, or 
disability, or in the case of certain corporate acquisitions. In addi- 
tion, under the Act, the 84-month rule does not apply to distribu- 
tions upon termination of the tax-credit ESOP, effective with re- 
spect to plan terminations after December 31, 1984. 

Explanation of Provision 

The bill clarifies that the exception to the 84-month rule for dis- 
tributions on termination of a tax-credit ESOP is available only 
with respect to lump-sum distributions (within the meaning of sec. 
401(k)(10)(B)(ii) as added by the bill) upon the termination of the 
plan without the establishment of a successor plan. The bill also 
clarifies that the exception is effective with respect to distributions 
(rather than plan terminations) occurring after December 31, 1984. 

In order to coordinate the 84-month rule with the new diversifi- 
cation rules, the bill provides that the 84-month rule does not 
apply to the extent that a distribution is made to satisfy the diver- 
sification requirement. This exception to the 84-month rule applies 
only to the extent that the diversification requirement cannot be 
satisfied by distributing employer securities that have already met 
the 84-month rule. 

c. Timing of distributions 

/Present Law 

The Act modified the rules relating to the timing and form of re- 
quired distributions. Under the Act, an ESOP is to permit earlier 
distributions to employees who separate from service before normal 
retirement age. Unless an employee otherwise elects in writing, the 
payment of benefits under an ESOP is to begin no later than 1 
year after the close of the plan year (1) in which the participant 
separates from service by reason of attainment of normal retire- 
ment age under the plan, or (2) that is the fifth plan year following 
the participant's separation from service for any other reason, 
unless the participant is reemployed by the employer before such 
year. The Act provided a special rule with respect to the portion of 
the participant's account (if any) that consists of securities acquired 
with an exempt loan. 

The rules added by the Act accelerate the otherwise applicable 
benefit commencement date. Accordingly, if the general rules (sees. 
401(a)(9) and 401(a)(14)) require the commencement of distributions 



159 

at an earlier date, those general rules override the special ESOP 
rules. 

Explanation of Provision 

Under the special distribution rule applicable to ESOPs, the bill 
provides that, in the case of a separation from service for reasons 
other than separation on or after normal retirement age, death, or 
disability, distributions are not required to begin if the participant 
returns to service with the employer prior to the time distribution 
is otherwise to begin under the rule. 

d. Right to demand employer securities 

Present Law 

A participant in an ESOP who is entitled to a distribution under 
the plan has the right to demand that the participant's benefits be 
distributed in the form of employer securities. 

Explanation of Provision 

To coordinate with the new diversification rules, the bill provides 
that a participant does not have the right to demand that benefits 
be paid in the form of employer securities with respect to the por- 
tion of the participant's account that the participant elected to di- 
versify. 

e. Voting 

Present Law 

An ESOP (or other defined contribution plan other than a profit- 
sharing plan) that is established by an employer whose stock is not 
publicly traded is generally required to pass through certain voting 
rights to plan participants (sec. 401(a)(22)). Under the Act, the pass- 
through voting requirement is eliminated with respect to employer 
securities issued by an employer whose stock is not publicly traded 
if a substantial portion of the employer's business consists of pub- 
lishing a newspaper for general circulation on a regular basis. 

Explanation of Provision 

The bill incorporates in the statute the provision in the State- 
ment of Managers that the exception to the voting rules applies to 
an employer (determined without regard to the controlled group 
rules) whose business consists of publishing a newspaper for gener- 
al circulation on a regular basis. Thus, the exception does not 
apply to members of the controlled group that do not meet this re- 
quirement. 

The bill replaces the term "not publicly traded" in section 
401(a)(22) with the term "not readily tradable on an established 
market" to conform to the term used in section 409. 



160 

2. Estate tax deduction for sales to an ESOP® (sec. lllB(g) of the 
bill, sec. 1172 of the Reform Act, and sees. 409 and 2057 of the 
Code) 

Present Law 

The Act permits a deduction from the gross estate of 50 percent 
of the qualified proceeds from a qualified sale of employer securi- 
ties. Under the Act, a qualified sale means any sale of employer 
securities (within the meaning of sec. 409(1)) by an executor to (1) 
an ESOP described in section 4975(e)(7), or (2) an eligible worker- 
owned cooperative (as defined in sec. 1042(c)(2)). 

Under the Act, certain penalties apply if any portion of the 
assets attributable to employer securities acquired in a qualified 
sale (or assets in lieu thereof) accrue or are allocated during the 
nonallocation period for the benefit of (1) a decedent whose estate 
makes such a sale, (2) any person who is related to the decedent in 
one of the ways described in section 267(b), or (3) any other person 
who owns (after application of the attribution rules of sec. 318(a) as 
modified for this purpose) more than (a) 25 percent (by number) of 
any class of outstanding stock of the corporation (or certain related 
corporations) that issued such qualified securities, or (b) more than 
25 percent of the total value of any class of outstanding stock of 
the corporation (or certain related corporations). 

There are 2 sanctions for failure to comply with the allocation 
restriction. First, the Act requires that an ESOP that acquires se- 
curities in a qualified sale is required to provide that the restric- 
tion on the allocation of securities (or assets in lieu thereof) to the 
sellers, family members, and 25-percent shareholders will be satis- 
fied. Failure to comply with this requirement results in disqualifi- 
cation of the plan with respect to those participants who received 
prohibited allocations. Thus, failure to comply results in income in- 
clusion for those participants of the value of their prohibited allo- 
cations on the date of such allocations. Second, if there is a prohib- 
ited allocation or accrual, then a 50 percent excise tax is imposed 
on the amount involved in the prohibited allocation (sec. 4979A). 

Explanation of Provision 

The bill conforms the nonallocation rules applicable to sales 
under section 2057 to the nonallocation rules applicable to sales 
under section 1042 (relating to nonrecognition treatment for cer- 
tain sales of stock to an ESOP). With respect to the rule prohibit- 
ing allocation or accrual of benefits under a plan attributable to se- 
curities acquired in a qualified sale (or assets in lieu of such securi- 
ties), the bill clarifies that the nonallocation period is the period be- 
ginning on the date of the sale and ending on the date that is 10 
years after the later of (1) the date of sale or (2) the date of the 
plan allocation attributable to the final payment of acquisition in- 
debtedness incurred in connection with such sale. 



* H.R. 1311 and S. 591 (100th Cong.) would make modifications to sec. 2057. The modifications 
are designed to conform the provision to Congressional intent and to reduce the revenue loss of 
the provision to the original level estimated during consideration of the Tax Reform Act of 1986. 



161 

The bill also provides that individuals who are ineligible to re- 
ceive an allocation of securities (or other assets) solely because they 
are lineal descendants of the decedent can receive an allocation of 
the securities acquired in the qualified sale provided that the total 
amount of such securities (or assets in lieu thereof) allocated to all 
such lineal descendants is not more than 5 percent of all employer 
securities acquired in the qualified sale. 

Finally, the bill clarifies that, in the case of a plan which fails to 
comply with the nonallocation rules, the statutory period for the 
assessment of the excise tax imposed with respect to such failure 
(sec. 4979A) is extended. 

3. Partial exclusion of interest earned on ESOP loans (sec. 
lllB(h) of the bill, sec. 1173 of the Reform Act, and sec. 133 
of the Code) 

Present Law 

In general 

Under present law, a bank, an insurance company, regulated in- 
vestment company, or a corporation actively engaged in the busi- 
ness of lending money may exclude from gross income 50 percent 
of the interest received with respect to a securities acquisition loan. 
A "securities acquisition loan" is generally defined as a loan to a 
corporation or to an ESOP to the extent that the proceeds are used 
to acquire employer securities (within the meaning of section 
409(1)) for the ESOP. There has been some confusion as to the 
availability of the partial interest exclusion with respect to refin- 
ancings of the various types of securities acquisition loans. 

Back-to-back loans 

The Act clarified the definition of a securities acquisition loan in 
the case of a loan to a corporation with a corresponding loan to an 
ESOP that is exempt under section 4975 (a back-to-back loan). The 
Act provides that a loan to a sponsoring corporation will qualify as 
a securities acquisition loan if the terms of such loan are substan- 
tially similar to the terms of the corresponding exempt loan from 
the corporation to the ESOP. In addition, the Act provides that, if 
the terms of the 2 loans are not substantially similar, the loan to 
the sponsoring corporation will still qualify as a securities acquisi- 
tion loan if (1) the corresponding loan to the ESOP provides for 
more rapid payment of principal or interest than the loan to the 
sponsoring corporation; (2) the allocations of stock within the ESOP 
attributable to the difference in payment schedules do not result in 
discrimination in favor of highly compensated employees; and (3) 
the total commitment period of the loan to the sponsoring corpora- 
tion is not more than 7 years. 

The 7-year limitation applies to the total commitment period. 
Thus, provided the final maturity of the credit arrangement is not 
greater than 7 years, the funds may be provided by 1 or more lend- 
ers in a series of shorter maturity loans, each of which (other than 
the first) is used to repay the preceding loan. 

The 7-year limitation on the term of the loan does not apply to 
loans directly from a commercial lender to an ESOP or to back-to- 



162 

back loans if the terms of the loans are substantially similar. For 
example, assume a bank makes a loan to employer X with a term 
of 10 years and employer X in turn makes a loan to its ESOP. If 
the terms of the 2 loans are substantially similar, then the partial 
interest exclusion is available for the entire 10-year commitment 
period of the loan. Similarly, the partial interest exclusion applies 
for the entire commitment period of the loan if the loan is made 
directly from the bank to the ESOP. 

Immediate allocation loans 

The Act extended the definition of "securities acquisition loan" 
to include certain loans to a corporation that are used by the corpo- 
ration to purchase employer securities that are immediately allo- 
cated to employees' accounts. Thus, the partial exclusion is avail- 
able with respect to interest paid on a loan to a corporation to the 
extent that (1) within 30 days of the date of the loan, employer se- 
curities are transferred to the ESOP in an amount equal to the 
proceeds of the loan, (2) such contributions are allocable to ac- 
counts of plan participants within 1 year of the date of the loan, 
and (3) the total commitment period of the loan does not exceed 7 
years. 

As in the case of other loans to which the 7-year limitation ap- 
plies, the limitation applies to the total commitment period. Thus, 
provided the final maturity of the credit arrangement is not great- 
er than 7 years, the funds may be provided by 1 or more lenders in 
a series of shorter maturity loans, each of which (other than the 
first) is used to repay the preceding loan. 

Refinancings 

The Act provided that, in certain cases, the refinancing of a secu- 
rities acquisition loan (other than an immediate allocation loan or 
a back-to-back loan that has terms that are not substantially simi- 
lar, which are discussed above) may also qualify as a securities ac- 
quisition loan. 

All refinancings, including refinancings of back-to-back loans 
that are not substantially similar, are required to comply with sec- 
tion 4975. 

Explanation of Provision 
In general 

The bill clarifies the availability of the partial interest exclusion 
in the case of refinancings of the various types of securities acquisi- 
tion loans. 

Back-to-back loans 

The bill provides that, with respect to back-to-back loans the 
terms of which are not substantially similar, if the total commit- 
ment period of the loan is extended beyond 7 years, the partial ex- 
clusion will be available, but for the first 7 years of the loan only. 
This 7-year period begins as of the date of the original loan. The 
provision is effective with respect to a loan used to acquire employ- 
er securities after July 18, 1984, and a loan made after July 18, 
1984, that is used (or is part of a series of loans used) to refinance a 



163 

loan that (1) was used to acquire employer securities after July 18, 
1984, and (2) met the requirements of section 133 of the Code as in 
effect at the time the loan was made. 

Immediate allocation loans 

The bill provides that, with respect to immediate allocation 
loans, if the total commitment period is extended beyond 7 years, 
the partial interest exclusion will be available, but for the first 7 
years of the loan only. This 7-year period begins as of the date of 
the original loan. This provision is effective as if included in the 
Act. 

Refinancings 

The bill provides that a loan to an ESOP (other than an immedi- 
ate allocation loan or a back-to-back loan that has terms that are 
not substantially similar) after July 18, 1984, that is used (or is 
part of a series of loans used) to refinance a loan will qualify as a 
securities acquisition loan provided that (1) the original loan met 
the requirements of section 133(b)(1) as in effect on the date of the 
loan, or, if later, July 19, 1984; and (2) the original loan was used to 
acquire employer securities after May 23, 1984. Immediate alloca- 
tion loans and back-to-back loans which have terms that are not 
substantially similar are described above. 

Under the bill, if a securities acquisition loan (other than an im- 
mediate allocation loan or a back-to-back loan that has terms that 
are not substantially similar) is refinanced and as a result the total 
commitment period exceeds the greater of the original commitment 
period or 7 years, then the partial exclusion would continue to 
apply, but only during the first 7 years of the commitment period 
(measured from the date of the original loan) or the original com- 
mitment period, whichever is greater. For example, if an otherwise 
qualified securities acquisition loan to an ESOP with an original 
commitment period of 5 years is refinanced and the commitment 
period is extended for 2 years (for a total commitment period of 7 
years), the partial exclusion would apply during the entire 7 years 
of the loan. 

Under the bill, as under the Act, if the terms of the back-to-back 
loans are no longer substantially similar as a result of the refinanc- 
ing, the partial exclusion would be available only during the first 7 
years of the loan. 

4. Sales of stock to an ESOP (sec. 118(q) of the bill, sec. 1854 of 
the Reform Act, and sees. 404, 409, and 1042 of the Code) 

Present Law 

A taxpayer may elect to defer recognition of gain on the sale of 
certain qualified securities to an ESOP or to an eligible worker- 
owned cooperative to the extent that the taxpayer reinvests the 
proceeds in qualified replacement property within a replacement 
period (sec. 1042), 

Prior to the Act, nonrecognition treatment was not available if 
any portion of the assets attributable to employer securities ac- 
quired in a qualified sale (or assets in lieu thereof) accrued or were 
allocated during the nonallocation period for the benefit of (1) the 



164 

taxpayer involved in the nonrecognition transaction, (2) an}' 
member of the taxpayer's family (within the meaning of sec. 
267(b)), or (3) any other person who owned (after application of the 
sec. 318 attribution rules) more than 25 percent in value of any 
class of outstanding securities. Temporary Treasury regulations 
provided that, for purposes of determining whether an individual is 
a 25-percent shareholder, stock that is owned directly or indirectly 
by or for a qualified plan is not treated as outstanding (Temp. 
Treas. reg. sec. 1042-lT Q&A 2(a)(3)). 

The Act made several changes with respect to the nonallocation 
requirement. In particular, for purposes of determining whether an 
individual is a 25-percent shareholder, the Act provides that the al- 
location rules of section 318(a) are applied, without regard to the 
employee trust exception in paragraph (2)(B)(i). Thus, all allocated 
securities held by an ESOP are treated as securities owned by the 
ESOP participant and are also treated as outstanding securities. 
This provision is effective with respect to sales of securities after 
October 22, 1986. 

An excise tax is imposed with respect to certain dispositions of 
employer securities within 3 years of the date of a sale to which 
section 1042 applies (sec. 4978). 

Explanation of Provision 

In order to conform the statute to Congressional intent, the bill 
clarifies that the nonallocation period is the period beginning on 
the date of the sale and ending on the date that is 10 years after 
the later of (1) the date of sale or (2) the date of the plan allocation 
attributable to the final payment of acquisition indebtedness in- 
curred in connection with such sale. 

In some situations, the rules for determining whether an individ- 
ual is a 25 percent shareholder may be more favorable under the 
Act than under prior law. The provision of the Act, however, is ef- 
fective prospectively only. The bill provides that, for purposes of de- 
termining whether an individual is a 25-percent shareholder with 
respect to sales occurring before October 22, 1986, in taxable years 
beginning after July 18, 1984, all allocated securities held by an 
ESOP for an individual may be treated as outstanding with respect 
to the individual if securities allocated to the individual under the 
ESOP are treated as securities owned by the individual. This rule 
applies consistently to all individuals with respect to any sales to 
which section 1042 applies. 

The bill provides that the excise tax on certain distributions (sec. 
4978) does not apply to employer securities which are required to 
be disposed of pursuant to the new diversification rules. 

5. Dividends paid deduction (sec. lllB(h) of the bill, sec. 1173 of 
the Reform Act, and sec. 404(k) of the Code) 

Present Law 

Subject to certain requirements, an employer may deduct divi- 
dends paid in cash on employer stock held by an ESOP if, in ac- 
cordance with the plan provisions, (1) the dividend is paid in cash 
to the plan participants or their beneficiaries, (2) the dividend is 



165 

paid to the plan and distributed to participants or beneficiaries not 
later than 90 days after the close of the plan year in which paid, or 
(3) the dividend with respect to employer securities is used to make 
payments on a loan described in section 404(a)(9) (sec. 404(k)). 

Explanation of Provision 

The bill provides that, with respect to dividends used to make 
payments on a loan described in section 404(a)(9), the dividend de- 
duction is available both with respect to dividends on unallocated 
and allocated shares. However, dividends on allocated shares may 
be used to make payments on such a loan only if the account to 
which the dividend would have been allocated is allocated employ- 
er securities in an amount equal to the amount of the dividend 
that would have been allocated. In addition, such allocation must 
be made in the year the dividend would otherwise have been allo- 
cated. 



H. Technical Corrections to the Retirement Equity Act of 1984 
(sec. 118(q) of the bill, sec. 1898 of the Reform Act, sec. 417 of 
the Code, and sec. 205 of ERISA) 

Present Law 

Under present law, a plan is required to notify participants of 
their rights to decline a qualified preretirement survivor annuity 
before the applicable election period. Under the Act, the period 
during which notice is required to be provided to an individual is 
the latest of the following periods: (1) the period beginning with the 
first day of the plan year in which the participant attains age 32 
and ending with the close of the plan year in which a participant 
attains age 35; (2) a reasonable period of time after the individual 
becomes a plan participant; (3) a reasonable period of time after 
the survivor benefit applicable to a participant is no longer subsi- 
dized (as defined in sec. 417(a)(4); (4) a reasonable period of time 
after the survivor benefit provisions (sec. 401(a)(ll)) become applica- 
ble with respect to a participant; or (5) a reasonable period after 
separation from service in the case of a participant who separates 
from service before attaining age 35. 

Explanation of Provision 

The bill clarifies that the notice period in the case of a partici- 
pant who separates from service before age 35 overrides any other 
period during which notice might be required. In such a case, the 
bill provides that the notification period is a reasonable period 
after separation from service and such notice period is not included 
in the list of notice periods the last of which applies. 

This provision is effective for distributions after the date of en- 
actment of the bill. 

(166) 



XII. Foreign Tax Provisions (Sec. 112 of the Bill) 

A. Foreign Tax Credit (sec. 112(a)-(c) of the bill, sees. 1201, 1202, 
and 1203 of the Reform Act, and sees. 864, 902, and 904 of the 
Code) 

Under the foreign tax credit system, the United States reserves 
the right to collect full U.S. income tax on U.S. persons' foreign 
income, less any foreign income taxes imposed on that income. The 
mechanics of the foreign tax credit are such that the United States 
may collect little or no residual U.S. tax— after aggregate foreign 
taxes are credited — on income that is taxed abroad at below the 
U.S. rate. This results where the law permits a cross-crediting of 
taxes, sometimes referred to as "averaging": that is, where taxpay- 
ers are permitted to credit high foreign taxes paid on one stream of 
income against the residual U.S. tax otherwise due on other, light- 
ly taxed foreign income. 

While the Code does not and has not attempted to eliminate all 
cross-crediting among types of differently taxed income, it has in 
the past separated types of income for credit purposes, most recent- 
ly based on the character, rather than the country of origin, of 
income. The Act further separated certain income into the follow- 
ing newly defined "baskets": passive income, high withholding tax 
interest, financial services income, shipping income, and dividends 
from each noncontrolled section 902 corporation. 

1. Separate application of foreign tax credit provisions to finan- 
cial services income 

Present Law 

The "predominantly engaged" test and the priority of the financial 
services income basket 

The financial services income basket applies not only to income 
earned by an entity predominantly engaged in the active conduct of 
a banking, insurance, financing, or similar business, but also to 
income earned by a person in the active conduct of a banking, fi- 
nancing, or similar business, or earned in connection with certain 
insurance activities, even if that person is not predominantly so en- 
gaged. The types of income that the Act places in the financial 
services income basket of a "predominantly engaged" entity are 
not limited to the types of income included in the financial services 
basket of a person not predominantly engaged. For example, 
income that would otherwise be passive is treated as financial serv- 
ices income in the hands of a predominantly engaged entity, but 
remains passive in the hands of an entity that is not predominant- 
ly engaged. 

(167) 



168 

On the other hand, Congress intended that dividends from each 
noncontroUed section 902 corporation would be subject to their 
their own separate Umitation regardless of whether those dividends 
also met the definition of financial services income (or of passive 
income or shipping income or of any other separate limitation type 
of income). 

Generally, the Act places certain export financing interest in the 
overall limitation basket, that is, outside the separately defined 
limitation baskets, regardless of whether the entity deriving the in- 
terest is engaged in financial services. In addition, the financial 
services income basket excludes high withholding tax interest. 
Where a predominantly engaged entity earns interest qualifying as 
export financing interest that is subject to a 5-percent or greater 
gross basis tax, however. Congress intended that such interest be 
treated as financial services income. 

Modification of the look-through rule to prevent avoidance of the 
purpose of the separate limitations 

Under the Act's look-through provisions for characterizing cer- 
tain types of income that a U.S. shareholder derives from a con- 
trolled foreign corporation, interest income of the shareholder is 
generally to be treated as financial services income (without regard 
to high withholding taxes or other circumstances that would ordi- 
narily shift such interest out of the shareholder's financial services 
income basket) to the extent that the interest payment is properly 
allocable to financial services income of the controlled foreign cor- 
poration. At the same time, the Act requires the IRS to prescribe 
such regulations as may be necessary or appropriate to prevent 
manipulation of the character of income the effect of which is to 
avoid the purposes of the separate limitations. In granting this reg- 
ulatory authority Congress intended that the IRS invoke it to 
modify, in some cases, the application of the look-through rule. 

For example, if a U.S. person lends funds directly to an unrelat- 
ed foreign person whose country of residence imposes a withhold- 
ing tax of at least 5 percent on the interest paid on the loan, then 
the interest is high withholding tax interest subject to the separate 
limitation for such interest. United States banks might take the po- 
sition, however, relying upon the look-through rule for interest, 
that they can avoid the separate limitation for high withholding 
tax interest by lending funds to such a borrower through a subsidi- 
ary that is a controlled foreign corporation incorporated in the bor- 
rower's country, rather than lending those funds directly. Taxpay- 
ers might argue that, under the look-through rule for interest, in- 
terest received in turn by the U.S. bank from the foreign subsidi- 
ary will not be high withholding tax interest, even though it at- 
tracts the foreign country's high withholding tax. 

Because such a result would undermine the separate limitation 
for high withholding interest. Congress intended that it be preclud- 
ed under the anti-avoidance regulations. It was expected that such 
regulations might treat the interest received by the U.S. bank from 
the foreign subsidiary in this example as high withholding tax in- 
terest. 



169 

Overall basket treatment of highly taxed financial services income 
of a controlled foreign corporation 

Where the taxpayer establishes to the satisfaction of the Secre- 
tary, pursuant to Code section 954(b)(4), that income of a controlled 
foreign corporation was taxed at over 90 percent of the maximum 
federal rate, the Act provides that dividends paid by the controlled 
foreign corporation out of its financial services income (as well as 
dividends paid out of the controlled foreign corporation's passive 
income and shipping income) are to be treated as overall basket 
income to the taxpayer. 

Explanation of Provision 

The predominantly engaged test and the priority of the financial 
services income basket 

Under the bill only income of persons predominantly engaged in 
the active conduct of a banking, insurance, financing, or similar 
business is separated into the financial services income basket. The 
bill therefore simplifies the foreign tax credit somewhat, relieving 
taxpayers from the necessity of computing a separate limitation 
with respect to a very limited type of income (i.e., non-passive, fi- 
nancial service income of an entity not predominantly engaged in 
providing such services) that generally could be expected to yield 
relatively insignificant amounts of additional tax revenues. 

The bill clarifies that dividends from a noncontrolled section 902 
corporation which would otherwise meet the definition of financial 
services income are placed in the separate basket for that corpora- 
tion's dividends. Thus the bill prevents banks and other financial 
businesses from receiving unintended relief from the 902 basket 
provisions not available to non-financial businesses. 

Where a predominantly engaged U.S. person earns export financ- 
ing interest (as defined by the Act) that is subject to a 5-percent or 
greater gross basis tax, the bill clarifies that this interest is finan- 
cial services income, rather than overall limitation income. In gen- 
eral, this treatment makes it clear that the Code allows cross-cred- 
iting of high taxes on such income against U.S. tax on lower-taxed 
financial services income, supplementing the favored treatment 
provided in the Act that allows cross-crediting of high taxes on 
overall basket income against U.S. tax on lower-taxed export fi- 
nancing interest. 

Modification of the look-through rule to prevent avoidance of the 
purpose of the separate limitations 

The bill eliminates the look-through treatment of interest subject 
to 5-percent or greater gross basis tax that is paid to a U.S. share- 
holder by a controlled foreign corporation out of income that would 
otherwise be treated under the look-through rules as financial serv- 
ices income. This provision makes it clear that lenders are prevent- 
ed from shifting high withholding tax interest into the financial 
services basket by the mere interposition of a controlled local 
entity between themselves and foreign borrowers. 



170 

Overall basket treatment of highly taxed financial services income 
of a controlled foreign corporation 

The bill provides for separate basket treatment of dividends paid 
by controlled foreign corporations where paid out of the latter's fi- 
nancial services income (or shipping income), even where it has 
been established pursuant to section 954(b)(4) that the controlled 
foreign corporation's income was taxed by a foreign government at 
more than 90 percent of the maximum LF.S. rate. Thus, for exam- 
ple, a dividend from a highly taxed banking subsidiary will be 
available for cross-crediting against U.S. tax on other lower-taxed 
financial services income of the parent. 

2. Shipping income 

Present Law 

The Act establishes a separate foreign tax credit limitation for 
shipping income. This limitation applies to income received or ac- 
crued by any person which is of a kind that would be foreign base 
company shipping income under Code sec. 954(f). The Act did not 
provide express ordering rules to determine the correct basket for 
income that could be placed in the shipping basket or a basket for 
dividends from a noncontrolled section 902 corporation. However, 
as indicated above, Congress intended the baskets for section 902 
corporations to take priority over the shipping basket. 

As in the case of financial services income described above, 
where the taxpayer establishes to the satisfaction of the Secretary 
that income of a controlled foreign corporation was taxed at over 
90 percent of the maximum federal rate, the Act provides that divi- 
dends paid by the controlled foreign corporation out of its shipping 
income are to be treated as overall basket income to the taxpayer. 

Explanation of Provision 

The bill provides that dividends from a noncontrolled section 902 
corporation that might otherwise constitute shipping income are to 
be placed in that corporation's dividend basket rather than the 
shipping basket, consistent with Congress' intent generally to give 
first priority to the section 902 dividend baskets. 

As in the case of financial services income, the bill provides for 
separate basket treatment of dividends paid by a controlled foreign 
corporation out of its shipping income when the taxpayer estab- 
lished to the satisfaction of the Secretary that the income was 
taxed by a foreign government at more than 90 percent of the max- 
imum tJ.S. rate. Thus, taxpayers may cross-credit taxes on any 
highly taxed shipping income against the U.S. tax on other ship- 
ping income they may earn. 

3. Transition rule for high withholding tax interest on qualified 

loans 

Present Law 

Generally for taxable years beginning after December 31, 1986, 
interest income subject to a foreign withholding tax or other gross 
basis tax of 5 percent or more (other than export financing inter- 



171 

est) is "high withholding tax interest" subject to its own separate 
foreign tax credit treatment. A special transition rule applies, how- 
ever, to certain interest on certain loans to any of 33 foreign coun- 
tries or to any resident of one of those countries for use in that 
country. The applicability of the transition rule turns on the 
amount of loans held by the taxpayer on November 16, 1985 and 
during subsequent taxable years. 

Explanation of Provision 

The bill provides that for purposes of this transition rule, all 
members of an affiliated group of corporations filing a consolidated 
return shall be treated as one corporation. (Under this rule, inter- 
company loans are eliminated.) Thus, for members of a consolidat- 
ed group, the transition relief will be available regardless of, and 
will be limited without regard to, the particular group member 
holding qualified loans on November 16, 1985, or during the rele- 
vant subsequent taxable year. 

4. Passive income 

Present Law 

Related party factoring income 

Under the related party factoring rules of the Tax Reform Act of 
1984, any income of a controlled foreign corporation from a loan to 
a person for the purpose of financing the purchase of inventory 
property of a related person was interest for separate foreign tax 
credit limitation purposes without regard to the exceptions to prior 
law's separate limitation for interest. Under the 1986 Act, such 
income of a controlled foreign corporation is also ineligible for the 
export financing exception to the new separate limitations (sec. 
864(d)(5)(A)(i)). In the case of passive income, this result follows be- 
cause the Act defines passive income generally as income "of a 
kind which would be foreign personal holding company income" 
(Code sec. 904(d)(2)(A)(i)); if export financing interest fits that de- 
scription, the related party factoring rules make unavailable the 
export financing exception from passive basket treatment which 
would otherwise be available. 

Congress did not intend that the availability of the export financ- 
ing exception for interest received directly by U.S. persons (rather 
than by controlled foreign corporations) be restricted by the 1984 
factoring rule governing loans made to finance inventory property 
purchases, or by the analogous 1986 rule. However, the phrase "of 
a kind which would be foreign personal holding company income" 
arguably leads to an inference that interest income earned directly 
by U.S. persons (i.e., interest that would be foreign personal hold- 
ing company income if the recipient was a controlled foreign corpo- 
ration) is ineligible for overall basket treatment under the export 
financing exceptions. 

Income inclusions under sections 551 and 1293 

Foreign personal holding company inclusions (under Code sec. 
551) and passive foreign investment company inclusions (under new 
Code sec. 1293) are passive income. In the case of a passive foreign 



172 

investment company inclusion, Congress intended that the high-tax 
kick-out shift the inclusion to the overall limitation basket, howev- 
er, if the creditable foreign tax with respect to the inclusion ex- 
ceeds the U.S. tax on the inclusion. 

Explanation of Provision 
Related party factoring income 

The bill clarifies that in determining whether income is "of a 
kind which would be foreign personal holding company income" 
the related person factoring rules applicable to controlled foreign 
corporations shall apply only in the case of an actual controlled 
foreign corporation. Thus, income earned directly by a U.S. person 
may be eligible for the applicable export financing exceptions. 

Income inclusions under sections 551 and 1293 

The bill amends the Code to make it clear that income inclusions 
under section 1293 are subject to recharacterization (e.g., by virtue 
of the high-tax kick-out), as are other kinds of income generally 
categorized as passive. 

5. Separate application of foreign tax credit limitation to income 
of controlled foreign corporations under the look-through rules 
in general 

Present Law 
Payments by controlled foreign corporations to U.S. shareholders 

A payment of interest, rent, or a royalty is ordinarily character- 
ized as separate or overall limitation income under the general 
rules defining the new separate limitation categories (sec. 904(d)(2)). 
Under the look-through rules of new Code section 904(d)(3), howev- 
er, any interest, rent, or royalty which is received or accrued from 
a controlled foreign corporation by a U.S. shareholder will be treat- 
ed as separate category income to the extent it is properly allocable 
to separate category income of the controlled foreign corporation. 

Without a mechanism to determine which set of rules takes prec- 
edence, the application of the look-through rules, on the one hand, 
and the general definitions of 904(d)(2), on the other, could produce 
conflicting results. For example, interest paid to a U.S. shareholder 
by a controlled foreign corporation earning only overall limitation 
income may be subject to a high withholding tax. Also, interest 
may be paid by a controlled foreign corporation to its U.S. share- 
holder to finance sales by the U.S. shareholder. On the one hand, 
this interest may qualify as export finance interest; on the other 
hand, the interest may be properly allocable to the controlled for- 
eign corporation's income unrelated to export financing. 

Congress intended that the question whether interest received 
from a controlled foreign corporation by a U.S. shareholder of the 
corporation is overall limitation income or a separate limitation 
type of income generally depend upon the application of the look- 
through rules to that interest, not upon the direct application of 
the export financing exception or the high withholding tax basket 
to that interest. In the case of high withholding tax interest. Con- 



173 

gress expected the IRS to promulgate regulations specifying cir- 
cumstances where it might be necessary to reverse the priority of 
the look-through rule in order to forestall abuse of the separate 
basket rules, as described above. 

Under the high-tax kick-out of section 904, the passive income 
basket generally excludes high-taxed income, that is, income sub- 
ject to foreign taxes paid or deemed paid by the taxpayer at rates 
higher than the maximum federal rates. As with financial services 
income and shipping income discussed above, the Act provides that 
for purposes of applying the dividend look-through rule, income 
that would otherwise be passive basket income will instead go into 
the overall limitation basket if the taxpayer establishes to the sat- 
isfaction of the Secretary, pursuant to Code section 954(b)(4), that 
such income was subject to an effective rate of income tax imposed 
by a foreign country greater than 90 percent of the maximum fed- 
eral rate of tax. 

In the case of payments of interest, rents, and royalties to the 
U.S. shareholder out of income of a controlled foreign corporation 
that would otherwise be passive, the combined effect of the look- 
through and high-tax kick-out rules may have been unclear. 

De minimis exception 

If a controlled foreign corporation has no foreign base company 
income or subpart F insurance income in a taxable year because 
the subpart F de minimis rule (Code sec. 954(b)(3)(A), as amended 
by the Act) is satisfied for that year, then interest, rents, or royal- 
ties paid by the corporation during that year and dividends, to the 
extent treated as paid from that year's earnings and profits, are 
not treated as income in a separate limitation category. 

Explanation of Provision 
Payments by controlled foreign corporations to U.S. shareholders 

The bill provides a general rule that income of the U.S. share- 
holder allocable to separate category income of a controlled foreign 
corporation will retain that character in the hands of the U.S. 
shareholder, subject to the high-tax kick-out (and to another excep- 
tion, described above, relating to interest paid by a controlled for- 
eign corporation bearing a high withholding tax but attributable to 
financial services income). For example, as intended by the Act, the 
bill makes it explicit that interest that technically may qualify as 
export financing interest paid by a controlled foreign corporation 
to a U.S. shareholder out of the corporation's passive income will 
be in the shareholder's passive basket rather than its overall 
basket. 

The bill makes it clear that the high-tax kick-out applies only at 
the U.S. shareholder level, not at the controlled foreign corporation 
level. Income of the U.S. shareholder out of the controlled foreign 
corporation's passive basket will be subject to the kick-out based on 
the entire amount of foreign tax imposed on the U.S. shareholder's 
income. Thus, where a withholding tax is imposed on royalties paid 
by a controlled foreign corporation to a U.S. shareholder out of pas- 
sive income, the shareholder's income will be in the overall basket 



174 

if the withholding tax is high enough to trigger the high-tax kick- 
out after allocation of U.S.-borne expenses. 

De minimis exception 

The bill limits the effect of the provision that treats income satis- 
fying the de minimis rule as non-separate limitation income. Under 
the bill, this treatment applies only to the controlled foreign corpo- 
ration's foreign base company income (determined without regard 
to deductions otherwise taken into account for subpart F purposes 
under sec. 954(b)(5)) and gross insurance income for the taxable 
year, as that term is generally used for subpart F purposes. 

6. Deflnition of high withholding tax interest 

Present Law 

The Act defines high withholding tax interest generally as any 
interest (other than export financing interest) subject to a foreign 
withholding tax (or other tax determined on a gross basis) of 5 per- 
cent or more. The Act further states that the Secretary may by 
regulations provide that amounts (not otherwise high withholding 
tax interest) will be treated as high withholding tax interest where 
necessary to prevent avoidance of the purposes of the separate lim- 
itations. Congress intended these rules to encompass foreign gross- 
basis taxes and other taxes that are substantially similar in the 
sense that their imposition results in heavier taxation by the levy- 
ing country of foreign lenders than of residents. 

Explanation of Provision 

The bill gives the Secretary authority to exclude from the defini- 
tion of withholding taxes, for these purposes, those taxes that are 
in the nature of a prepayment of a tax imposed on a net basis, 
where the tax in question is otherwise free of those characteristics 
of a gross-basis tax that would warrant treatment as high with- 
holding taxes. Thus, the bill makes clear that where a foreign 
taxing authority uses withholding simply as a collection mecha- 
nism (as does the United States in the cases of ordinary wage with- 
holding and backup withholding on certain interest, dividend, and 
other reportable payments under Code section 3406), it will not nec- 
essarily follow that the mechanism results in interest being treated 
as high withholding tax interest. 

7. Deemed-paid credit 

Present Law 

The Act clarifies that the deemed-paid credit limitation rules 
(Code sec. 902) and the subpart F deemed-paid limitation rules (sec. 
960), as well as the general foreign tax credit limitation rules (sec. 
904(a)-(c)) and the separate foreign oil and gas limitation rules (sec. 
907), apply separately to categories of income subject to the sepa- 
rate limitations. The Act also gives the Secretary authority to pro- 
vide such regulations as may be necessary or appropriate to carry 
out both sets of deemed-paid limitation rules, but in so doing, refers 
to specific authority to regulate the separate application of section 



175 

904 to deemed-paid taxes only in the case of taxes deemed paid 
under section 902. 

The Act provides that for purposes of computing the deemed-paid 
foreign tax credit, dividends or subpart F inclusions are considered 
made first from the post-1986 pool of all the distributing corpora- 
tion's accumulated earnings and profits. In the case of taxes 
deemed paid under section 902 on dividends, the Act defines the 
term "post-1986 undistributed earnings" by reference to the defini- 
tions of earnings and profits in sections 964 (prescribing rules for 
the computation of earnings and profits of a foreign corporation) 
and 986 (prescribing rules for the translation of a foreign corpora- 
tion's foreign currency denominated earnings into dollars). 

Section 964 has 3 subsections. Subsection 964(a) provides general- 
ly for the computation of earnings of foreign corporations in a way 
substantially similar to the earnings of a domestic corporation, 
with some exceptions. Subsection 964(b) excludes blocked income, 
for purposes of Code sections 952, 955, and 956, from earnings and 
profits of a controlled foreign corporation. Blocked income is 
income that is shown, to the satisfaction of the Secretary of the 
Treasury, to be unavailable for distribution by a controlled foreign 
corporation to United States shareholders due to currency or other 
restrictions or limitations imposed under the laws of any foreign 
country. Subsection 964(c) provides record-keeping and record dis- 
closure rules for purposes of enforcing subpart F and subpart G (re- 
lating to export trade corporations). 

Explanation of Provision 

The bill clarifies that the Secretary's authority to provide such 
regulations as may be necessary to carry out the provisions of the 
subpart F deemed-paid credit rules in section 960 is to include au- 
thority to provide for, inter alia, the separate application of section 
960 (as well as the separate application of section 902) to reflect the 
separate application of the section 904 rules to separate types of 
income and loss. 

The bill amends the definition of "post-1986 undistributed earn- 
ings" under section 902, so that it will direct the computation of 
earnings and profits of the foreign corporation in accordance with 
subsection 964(a) (rather than section 964 as a whole) and section 
986. Thus, the bill clarifies that the blocked income provisions of 
964(b) are irrelevant to the computation of the post-1986 undistrib- 
uted earnings pool for purposes of the deemed-paid credit on divi- 
dends. 

8. Recapture of foreign separate limitation losses 

Present Law 

The 1986 Act provided express rules to make it clear that losses 
in the new and existing separate limitation baskets do not reduce 
U.S. taxable income before foreign taxable income (new Code sec. 
904(f)(5)). The new rules provide that losses for any taxable year in 
a separate foreign tax credit limitation basket and in the overall 
limitation basket offset U.S. source income only to the extent that 
the aggregate amount of such losses exceeds the aggregate amount 



176 

of foreign income earned in other baskets. These losses (to the 
extent that they do not exceed foreign income for the year) are to 
be allocated on a proportionate basis among (and operate to reduce) 
the foreign income baskets in which the entity earns income in the 
loss year. 

By analogy to the overall foreign extraction loss recapture rules 
of section 907(c)(4), the Act further provides a loss recharacteriza- 
tion rule that applies to subsequent income. Where a basket previ- 
ously showed a separate limitation loss which was allocated against 
income in other baskets, subsequent income in the loss basket will 
be recharacterized as income of the type that it previously offset, in 
proportion to the prior loss allocation not previously taken into ac- 
count under this recharacterization provision. 

In addition to the Act's new separate basket loss recapture provi- 
sion and the overall foreign extraction loss recapture rules upon 
which the former is based, the Code provides a third rule, in effect 
since 1976, for recapture of overall foreign losses. This rule is de- 
signed to prevent taxpayers from benefiting from a combination of 
forgiveness of U.S. tax on a portion of current U.S. income (result- 
ing from the use of an overall foreign loss to reduce worldwide tax- 
able income below U.S. taxable income) and an allowance of a for- 
eign tax credit with respect to the full amount of subsequent years' 
foreign income. Under the rule, a portion of foreign taxable income 
earned after an overall foreign loss year is treated as U.S. taxable 
income for foreign tax credit purposes (Code sec. 904(f)(l)-(4)). 

Section 904(f)(3) contains gain recognition and characterization 
rules to ensure the recapture of an overall foreign loss where prop- 
erty which was used in a trade or business, and which was used 
predominantly outside of the United State, is disposed of prior to 
the time the loss has been recaptured by recharacterizing foreign 
income as U.S. taxable income. Under section 904(f)(3), gain on 
such a disposition is viewed as foreign source income to be rechar- 
acterized as U.S. source income until the loss is fully recaptured. 
Recapture occurs regardless of whether gain would otherwise have 
been recognized on the disposition. There is no provision analogous 
to section 904(f)(3) in the recapture rules for foreign oil and gas ex- 
traction losses, or in the Act's new separate limitation loss recap- 
ture provision. 

Explanation of Provision 

The bill adds a provision to the Act's separate loss recharacteri- 
zation rules stating that recognition rules similar to those of 
904(f)(3), applicable to an overall foreign loss, shall apply to any dis- 
position of property, the gain from which would be in an income 
category whose separate limitation loss was allocated against any 
separate limitation income. Thus, the bill achieves a result consist- 
ent with the general loss recharacterization rules of the Act in the 
case where losses in a category have been allocated against income 
in the other categories, and property generating income in the loss 
category is disposed of at a gain (whether or not the gain would be 
recognized for other Code purposes) before income in the other cat- 
egories has been restored to the full extent of losses allocated 
against them. 



B. Source Rules 

1. Determination of source in case of sales of personal property 
(sec. 112(d) and 112(z)(5) of the bill, sec. 1211 of the Reform 
Act, and sees. 338, 864, and 865 of the Code) 

Present Law 

Overview 

Prior to the Act, the source of income derived from the sale of 
personal property generally was determined by the place of sale 
(commonly referred to as the "title passage" rule). While the Act 
did not change the place-of-sale rule for most inventory sales, the 
Act generally did replace the place-of-sale rule for sales of other 
personal property with a residence-of-the-seller rule. 

Under the residence-of-the-seller rule (new sec. 865), income de- 
rived by U.S. residents from the sale of personal property, tangible 
or intangible, generally is sourced in the United States. Similarly, 
income derived by a nonresident of the United States from the sale 
of personal property, tangible or intangible, is generally treated as 
foreign source. For purposes of determining source, the term sale 
does not include a sale of intangible property to the extent pay- 
ments received in consideration for the sale are contingent on the 
productivity, use, or other disposition of the property. Payments 
that are so contingent are treated like royalties in determining 
their source. 

Definition of resident 

An individual is a resident of the United States for purposes of 
section 865 if the individual has a tax home (as defined in sec. 
911(d)(3)) in the United States. Any corporation, partnership, trust, 
or estate which is a United States person (as defined in sec. 
7701(a)(30)) is a U.S. resident for this purpose. Other individuals 
and entities generally are nonresidents for purposes of these source 
rules. 

Under the Act, regulations are to be prescribed by the Secretary 
carrying out the purposes of the Act's source rule provisions. One 
area where it was contemplated that regulations may be required 
is to prevent persons from establishing partnerships or corpora- 
tions, for example, to change their residence to take advantage of 
the new rules. It was anticipated that the establishment of an anti- 
abuse rule to treat, for example, a foreign partnership as a U.S. 
resident to the extent its partners are U.S. persons would be appro- 
priate. 

United States citizens and resident aliens who have tax homes 
outside of the United States are nevertheless considered U.S. resi- 
dents in one case. This case occurs when income from a sale is not 
subject to an effective foreign income tax of 10 percent or more. 

(177) 



73-917 0-87-7 



178 

This level-of-tax rule prevents U.S. citizens and resident aliens i 
from generating zero- or low-taxed foreign source income that 
might otherwise escape all tax. As a consequence of retaining prior 
law's place-of-sale rule for income derived from the sale of invento- 
ry and gain in excess of recapture derived from the sale of depre- 
ciable personal property, the level-of-tax rule does not apply to 
sales of these types of personal property but does apply to sales of 
all other types of personal property. 

Exceptions to residence rule 

Income derived from the sale of depreciable personal property 

The residence-of-the-seller rule does not apply to income derived 
from the sale of depreciable personal property, to the extent of 
prior depreciation deductions. This income is sourced under a re- 
capture principle. Specifically, gain to the extent of prior deprecia- 
tion deductions from the sale of depreciable personal property is 
sourced in the United States if the depreciation deductions giving 
rise to the gain were previously allocated against U.S. source 
income. If the deductions giving rise to the gain were previously al- 
located against foreign source income, gain from the sale (to the 
extent of prior deductions) is sourced foreign. If personal property 
is used predominantly in the United States for any taxable year, 
the taxpayer is to treat the allowable deductions for the year as 
being allocable entirely against U.S. source income. If personal 
property is used predominantly outside the United States for any 
taxable year, the taxpayer is to treat the allowable deductions for 
such year as being allocable entirely against foreign source income. 
(This special predominant-use rule does not apply for certain per- 
sonal property generally used outside the United States, namely, 
personal property described in sec. 48(a)(2)(B).) Any gain in excess 
of prior depreciation deductions is sourced pursuant to the place-of- 
sale rule. These rules apply without regard to the residence of the 
taxpayer. 

Depreciable personal property is any personal property if the ad- 
justed basis of the property includes depreciation adjustments. 
Thus, intangible property for which an amortization deduction is 
allowable is considered depreciable personal property. With respect 
to sales of intangible property, however, it is unclear under the Act 
whether the recapture rule applies to gain to the extent of amorti- 
zation recapture, and whether the general intangible rules or the 
place-of-sale rule as retained under the Act applies to gain in 
excess of amortization recapture. 

Income attributable to an office or other fixed place of busi- 
ness 

The residence-of-the-seller rule does not apply to income derived 
from the sale of personal property when the sale is attributable to 
an office or other fixed place of business outside the seller's resi- 
dence. 

For U.S. residents, this office rule applies to certain income de- 
rived from the sale of personal property when the sale is attributa- 
ble to an office or other fixed place of business maintained by the 
taxpayer outside the United States. With respect to U.S. residents, 



179 

individual or otherwise, however, the office rule applies only if an 
effective foreign income tax of 10 percent or more is paid to a for- 
eign country on the income from the sale. It is unclear under the 
Act if the office rule applies to income (in the form of noncontin- 
gent payments) derived from the sale of intangible property by a 
U.S. resident when the sale is attributable to a fixed place of busi- 
ness in a foreign country and the U.S. resident pays an income tax 
at an effective rate of 10 percent or more. 

Income derived from the sale of stock in foreign affiliates 

The residence-of-the-seller rule does not apply to income derived 
by U.S. corporations from the sale of stock in certain foreign affili- 
ates. If a U.S. corporation sells stock of a foreign affiliate in the 
foreign country in which the affiliate derived from the active con- 
duct of a trade or business more than 50 percent of its gross income 
for the 3-year period ending with the close of the affiliate's taxable 
year immediately preceding the year during which the sale occurs, 
any gain from the sale is foreign source. An affiliate, for this pur- 
pose, is any foreign corporation whose stock is at least 80 percent 
owned (by both voting power and value). It is unclear under the 
Act if this rule applies only to gain from the sale of stock in corpo- 
rations directly engaged in an active trade or business or also ap- 
plies to gain from the sale of stock in corporations indirectly en- 
gaged in an active trade or business. 

Other rules 

Prior to the Act, foreign source income derived from the sale of 
inventory property by a foreign person generally was treated as ef- 
fectively connected with the conduct of a U.S. trade or business if 
the sale was attributable to a U.S. office (or other fixed place of 
business) and sold through the U.S. office. The Act repealed this 
rule but generally made income derived from the sale of any per- 
sonal property by a foreign person when the sale is attributable to 
a U.S. office (or other fixed place of business) U.S. source. 

The Act's legislative history indicated that Congress intended 
that the Act's source rule changes prevail over treaty source rules 
to the extent necessary to insure that income not taxed by a for- 
eign country not escape U.S. tax as well. This policy was to apply 
to all the source rule changes in the Act, not just those applicable 
to personal property. 

Section 338 generally and 338(h)(10) in particular allow in certain 
circumstances a sale of stock in an affiliated corporation to be 
treated as a sale of the affiliated corporation's assets. As indicated 
above, a sale of stock in a U.S. corporation is sourced under the 
residence-of-the-seller rule while a sale of assets is sourced under 
the residence-of-the-seller rule, the place-of-sale rule, the rules re- 
lating to intangible property, or the recapture rule depending on 
the type of asset sold and the income generated therefrom. Thus, 
for example, if an election under section 338(h)(10) is made, the 
income inherent in the stock may or may not be sourced under the 
residence-of-the-seller rule. 



180 

Explanation of Provision 
Definition of resident 

The bill modifies the definition of resident in the case of partner- 
ships. Whereas the Act generally determined the source of income 
derived from sales of personal property by treating a partnership 
as a U.S. resident or nonresident based on its situs, the bill makes 
these determinations at the partner level, except as provided in 
regulations. In determining source, it is anticipated that, like the 
attribution of a U.S. trade or business under Code section 875, a 
U.S. office or other fixed place of business of the partnership will 
be attributed to its partners. 

The bill provides regulatory authority to determine source at the 
partnership level, for example, in cases where it is not administra- 
tively possible to apply the rules at the partner level. For example, 
it may be appropriate to determine source at the partnership level 
in the case of a publicly traded partnership which has hundreds of 
partners. 

The bill also modifies the 10-percent tax payment requirement 
(applicable to U.S. citizens and resident aliens maintaining tax 
homes outside the United States) for bona fide residents of Puerto 
Rico. The 10-percent tax payment requirement is waived for an in- 
dividual who is a bona fide resident of Puerto Rico for the entire 
taxable year on the sale of stock of a corporation which (directly or 
indirectly) (1) is engaged in an active trade or business in Puerto 
Rico, and (2) derives from the active conduct of a trade or business 
in Puerto Rico more than 50 percent of its gross income for the 3 
years preceding the year of sale. Under this rule, bona fide resi- 
dents of Puerto Rico who sell stock in certain corporations doing 
business in Puerto Rico generate Puerto Rican source income and, 
thus, retain the benefits of section 933. 

Exceptions to residence rule 

Income derived from the sale of depreciable personal property 

The bill clarifies that income to the extent of previously allowed 
amortization deductions derived from the sale of amortizable intan- 
gible property is sourced under the Act's recapture rule. The recap- 
ture rule applies whether or not the payments in consideration for 
the sale are contingent on the productivity, use, or disposition of 
the property. For sales where the payments are so contingent, it is 
intended that the source of all payments be determined under the 
recapture rule until the entire recapture amount has been recap- 
tured, and that any remaining payments be sourced under the gen- 
eral intangible rules. 

The bill also clarifies that gain derived from the sale of intangi- 
ble property in excess of amortization recapture is sourced under 
the residence-of-the-seller rule when the payments in consideration 
for the sale are not contingent on the productivity, use, or disposi- 
tion of the property. When payments are so contingent, the source 
rule for royalties applies to the gain. 



181 

Income attributable to an office or other fixed place of busi- 
ness 

The bill clarifies that the office rule as it applies to U.S. persons 
also applies to a sale of intangible property when the payments in 
consideration for the sale are not contingent on the productivity, 
use, or disposition of the property. Thus, a U.S. resident who sells 
intangible property for noncontingent payments generates foreign 
source income as long as the sale is attributable to a foreign office 
and an effective rate of foreign income tax of at least 10 percent is 
paid on the income derived from the sale. Further, the bill clarifies 
that the recapture rule prevails over the office rule to the extent of 
any recapture amount. 

Income derived from the sale of stock in foreign affiliates 

The bill clarifies that income derived from the sale of stock of a 
foreign affiliate which wholly owns another foreign corporation is 
treated as foreign source income in certain cases. Under this clari- 
fication, as long as either the parent or the subsidiary is engaged 
in an active trade or business in the country in which the sale 
occurs and 50 percent of the gross income of the holding company 
and the subsidiary combined for a three-year period is derived from 
the active conduct of a trade or business in that foreign country, 
then gain on the sale of stock in the holding company will be treat- 
ed as foreign source. 

Other rules 

The bill reinstates the provision repealed by the Act that treats 
foreign source income derived from certain sales of inventory prop- 
erty by a foreign person as effectively connected with the conduct 
of a U.S. trade or business. This provision is necessary to ensure 
that foreign persons who may be treated as U.S. residents for 
source rule purposes but as nonresidents for general purposes are 
taxed on income derived from sales of inventory property. 

The bill codifies the Act's legislative history by clarifying (in con- 
nection with the changes to sec. 7852(d)) that the Act's source rule 
changes generally prevail over any conflicting treaty source rules 
under the general later-in-time rule. The bill does provide, howev- 
er, an exception to the general later-in-time rule. Under this excep- 
tion, if a taxpayer, by claiming treaty benefits, treats as foreign 
source any gain derived from the sale of stock in a treaty country 
corporation which would be U.S. source under the Act, then foreign 
taxes on that gain cannot offset U.S. tax on any other item of 
income, and foreign taxes on any other item of income cannot 
offset U.S. tax on that gain. For example, under the Act, gain from 
the sale of stock in a less-than-80-percent owned foreign corpora- 
tion by a U.S. resident is U.S. source. A treaty may treat that 
income as foreign source. Under the bill, that income is subject to 
U.S. tax as foreign source income, but the U.S. resident may credit 
only foreign tax imposed on that income against the U.S. tax im- 
posed on that income. 

The bill provides, except as provided in regulations, that an elec- 
tion under section 338(h)(10) to treat a sale of stock in an affiliated 
corporation as a sale of assets does not treat that sale as a sale of 



182 

assets for purposes of determining source in determining the sell- 
er's foreign tax credit limitation. Instead, for these purposes, the 
gain is treated as a gain from the sale of stock. 

It is anticipated that any regulations prescribed under the gener- 
al regulatory authority provided under section 338 will limit the 
applicability of the scope of section 338 so that that section will not 
affect inappropriately the determination of source and of a taxpay- 
er's foreign tax credit limitation. Moreover, to the extent that regu- 
lations prescribed under section 336(e) extend the principles of sec- 
tion 338 to a sale of stock in a foreign corporation, it is anticipated 
that those regulations will not affect inappropriately the determi- 
nation of source and of a taxpayer's foreign tax credit limitation. 

The bill's modification to section 338(h)(10) is effective for trans- 
actions occurring after the date of the bill's introduction. 

2. Special rules for exemption from U.S. tax on U.S. source trans- 
portation income (sec. 112(e) of the bill, sec. 1212 of the Reform 
Act, and sees. 872 and 883 of the Code) 

Present Law 

The Code's reciprocal exemption provisions sometimes exempt 
foreign persons from U.S. tax on U.S. source transportation 
income. Prior to the Act, the reciprocal exemption provisions ex- 
empted foreign persons from U.S. tax on earnings derived from the 
operation of ships (or aircraft) documented under the laws of a for- 
eign country if that country exempted U.S. citizens and domestic 
corporations from its tax. The Act modified these provisions to pro- 
vide the exemption from U.S. tax only to alien individuals who are 
residents of, and foreign corporations organized in, a foreign coun- 
try which grants U.S. citizens and domestic corporations an equiva- 
lent exemption. 

A foreign corporation, in addition to having to be organized in a 
country that grants U.S. persons an equivalent exemption, must 
also satisfy a residence-based requirement to obtain U.S. tax ex- 
emption. The residence-based requirement requires that ultimate 
individual owners of more than 50 percent of the foreign corpora- 
tion be residents of a foreign country that grants U.S. citizens and 
domestic corporations an equivalent exemption. Thus, it is not 
enough for the foreign corporation to be organized in a foreign 
country which grants U.S. citizens and domestic corporations an 
equivalent exemption: individuals ultimately owning most of its 
stock must reside in such a country as well. Ultimate individual 
ownership is determined by treating stock owned directly or indi- 
rectly by or for any entity (for example, a corporation, partnership, 
or trust) as being actually owned by the stockholder (or partner, 
grantor, or beneficiary, as the case may be) of that entity and by 
further attributing that ownership to its owners if necessary to 
reach individual owners. 

The residence-based requirement does not apply to any foreign 
corporation organized in a foreign country that exempts U.S. per- 
sons from its tax if the stock of the corporation is primarily and 
regularly traded on an established securities market in that foreign 
country. This publicly traded exception also covers a foreign corpo- 



183 

ration that is wholly owned by a second corporation organized in 
the same country as the first foreign corporation if the stock of the 
second foreign corporation is primarily and regularly traded on an 
established securities market in that country. 

Explanation of Provision 

The bill modifies the reciprocal exemption provisions so that 
they operate independently with respect to nonresident alien indi- 
viduals and foreign corporations. Thus, for a nonresident alien indi- 
vidual to be exempt from U.S. tax, his or her country of residence 
must exempt only U.S. citizens from its tax. Similarly, for a foreign 
corporation to be exempt from U.S. tax, its country of organization 
must exempt only domestic corporations from that country's tax. 

The bill extends the publicly-traded exception to the residence- 
based requirement to certain foreign corporations that are wholly 
owned subsidiaries of third-country parent corporations. This ex- 
tension applies to a parent corporation that is organized in a coun- 
try that exempts domestic corporations from its tax if the parent 
corporation's stock is primarily and regularly traded on an estab- 
lished securities market in its country of organization. Thus, if 
both the parent corporation and its wholly-owned subsidiary are or- 
ganized in foreign countries that grant equivalent exemptions to 
U.S. corporations, and the stock of the former is primarily and reg- 
ularly traded in its country of organization, then the subsidiary is 
exempt from U.S. tax regardless of whether more than 50 percent 
of its stock is owned by local residents. 

3. Limitations on special treatment of 80/20 corporations (sec. 
112(f) of the bill, sec. 1214 of the Reform Act, and sees. 861 
and 2105 of the Code) 

Present Law 

Prior to the Act, a U.S. corporation's dividend and interest pay- 
ments were foreign source and not subject to U.S. withholding tax 
when at least 80 percent of the U.S. corporation's income over the 
prior three years was from foreign sources (commonly referred to 
as an 80/20 company). The Act repealed prior law as it applied to 
dividends paid by an 80/20 company (other than dividends paid by 
a possessions corporation) and treats dividends paid by U.S. corpo- 
rations as U.S. source. Dividends received by foreign persons from 
U.S. corporations, though treated as U.S. source, receive look- 
through treatment for U.S. withholding tax purposes when the cor- 
poration satisfies an active foreign business requirement. In such a 
case, the amount of the withholding tax exemption is based on the 
source of the income earned by the U.S. corporation. With respect 
to interest payments by a U.S. corporation, the Act generally treats 
the interest as U.S. source unless the corporation satisfies the 
active foreign business requirement. If the active foreign business 
requirement is met, the Act treats interest paid by a U.S. corpora- 
tion as foreign source if the interest is paid to unrelated parties 
and as having a prorated source based on the source of the payor's 
income if the interest is paid to related parties. 



184 

The active foreign business requirement is satisfied if at least 80 
percent of the U.S. corporation's gross income for the 3-year period 
preceding the year of the payment is derived from foreign sources 
and is attributable to the active conduct of a trade or business in 
one or more foreign jurisdictions (or U.S. possessions). 

The 80-percent active foreign business requirement may be met 
by the U.S. corporation alone or, instead, may be met by a group 
including domestic or foreign subsidiaries in which the U.S. corpo- 
ration owns a controlling interest. It is intended that at least a 50- 
percent ownership interest be required for a subsidiary's business 
to be attributed to a U.S. shareholder. In allowing attribution of a 
subsidiary's active foreign business to a controlling corporate 
shareholder, the character (i.e., active foreign business income) of 
the subsidiary's gross income is intended to be attributed to the 
corporate shareholder only on the actual inclusion of income from 
the subsidiary, for example, dividends, interest, rents, or royalties, 
and for the purpose of determining the percentage of dividends 
paid by the shareholder that are subject to U.S. withholding tax. 
Thus, for example, dividends received by a corporate shareholder 
from controlled U.S. subsidiaries, though treated as U.S. source in 
the hands of the corporate shareholder, are to be characterized as 
active foreign business income for the purpose of this look-through 
rule in the same proportion that the controlled subsidiaries' active 
foreign business income bears to their total income. With respect to 
other items of income received from controlled subsidiaries, those 
amounts are to be characterized as active foreign business income 
to the extent they are allocated against active foreign business 
income of the payor. 

Prior to the Act, certain income paid by U.S. persons to foreign 
persons was effectively exempted from U.S. withholding tax be- 
cause the income was treated as foreign source income. Under the 
Act, the income is treated as U.S. source, but the exemption from 
U.S. withholding tax is made explicit. The interest affected in- 
cludes interest on deposits with persons carrying on the banking 
business, interest on deposits or withdrawable accounts with a Fed- 
eral or State chartered savings institution as long as such interest 
is a deductible expense to the savings institution under section 591, 
and interest on amounts held by an insurance company under an 
agreement to pay interest thereon, but, in each case, only if such 
interest is not effectively connected with the conduct of a trade or 
business within the United States by the recipient of the interest. 
The Act also made an explicit exemption from U.S. withholding 
tax for income derived by a foreign central bank of issue from 
bankers' acceptances. By treating the interest on deposits as U.S. 
source, it is not intended that the principal amounts which gener- 
ate the income be includible in a foreign person's estate. 

Explanation of Provision 

The bill clarifies that, for purposes of attributing a lower-tier cor- 
poration's active foreign business income to an upper-tier U.S. cor- 
poration, the upper-tier corporation must own directly or indirectly 
at least 50 percent of both the voting power and value of the stock 
of the lower-tier corporation. 



185 

The bill clarifies that the change in source for certain interest on 
deposits does not change its treatment for estate tax purposes. 
Thus, for example, bank deposits the interest on which is not effec- 
tively connected with a U.S. trade or business, though such interest 
is treated as U.S. source income, are not treated as property within 
the United States. 

Further, the bill clarifies that the Act's provisions are generally 
effective for payments made in taxable years of the payor begin- 
ning after December 31, 1986. 

4. Rules for allocation of interest, etc., to foreign source income 
(sec. 112(g) of the bill, sec. 1215 of the Reform Act, and 864(e) 
of the Code) 

Present Law 
Basis of stock of nonaffiliated 10-percent owned corporation 

When the tax book value method of expense apportionment is 
used, the Act provides a new rule to allocate and apportion ex- 
penses on the basis of assets when the asset is stock in one of cer- 
tain corporations. If a 10-percent or more owned corporation is not 
included in the group treated as one taxpayer, then, in general, the 
adjusted basis of the stock owned in such corporation in the hands 
of a U.S. shareholder is increased by the amount of the earnings 
and profits of the corporation attributable to that stock and accu- 
mulated during the period the taxpayer held it. Earnings and prof- 
its are not limited to those accumulated in post-enactment years. 
(In general, two kinds of 10-percent owned corporations are not in- 
cluded in the one-taxpayer group: foreign corporations, and U.S. 
corporations that are more than 10- but less than 80-percent 
owned.) In the case of a deficit in earnings and profits of the corpo- 
ration that arose during the period when the U.S. shareholder held 
the stock, that deficit reduces the adjusted basis of the asset in the 
hands of the shareholder. In that case, however, the deficit cannot 
reduce the adjusted basis of the asset below zero. 

Under prior law and under the Act, subpart F inclusions in- 
crease stock basis in but do not decrease earnings and profits of a 
controlled foreign corporation (sees. 961 and 959). Congress did not 
intend that the addition of such amounts to stock basis by virtue of 
a subpart F inclusion (or another inclusion with an equivalent 
effect on basis) result in double counting. 

Allocation of expenses to deductible dividends 

The Act provides that for purposes of allocating or apportioning 
any deductible expense, any tax-exempt asset (and any income 
from such an asset) shall not be taken into account. A similar rule 
applies in the case of any dividend from a U.S. corporation that is 
eligible under section 243 for the 80-percent dividends received de- 
duction (but not in the case of a dividend from a U.S. corporation 
that is eligible for the 100-percent dividends received deduction) 
and in the case of any dividend from a foreign corporation a frac- 
tion of which (that reflects its U.S. earnings) is eligible under sec- 
tion 245(a) for an 80-percent dividends received deduction. 



186 

Treatment of bank holding companies and banks 

While the Act generally requires an affiliated group to be treated 
as if all members of the group were one taxpayer for purposes of 
allocating and apportioning interest expense, that general rule 
does not apply to any financial institution (described in section 581 ^ 
or 591) if the business of the financial institution is predominantly 
with persons other than related persons or their customers, and if \ 
the financial institution is required by State or Federal law to be 
operated separately from any other entity which is not a financial 
institution. A bank to which this exception applies is not treated as 
a member of the group for applying the Act's general one-taxpayer 
rule for interest expense allocation and apportionment to other 
members of the group; instead, that bank and all other banks in; 
the group are to be treated as one taxpayer (rather than each bank, 
being treated as a separate taxpayer for this purpose). 

Although treated separately from other group members for inter- 
est expense allocation, banks were to be treated as part of the over- 
all group that the Act treats as one taxpayer for expenses other 
than interest. The Act does not make this distinction. 

Direct allocation of interest expense when deduction is denied 

The Act provides that the Secretary is to prescribe such regula- 
tions as may be necessary or appropriate to carry out the purposes 
of this section, including regulations providing for direct allocation 
of interest expense incurred to carry out an integrated financial 
transaction to any interest (or interest-type income) derived from 
such transaction. 

In certain cases, the dividends received deduction is reduced in 
cases where portfolio stock is debt financed (Code sec. 246A). In ad- 
dition, a life insurance company is allowed a dividends received de- 
duction for its share of dividends received, but this deduction is not 
allowed for the policyholders' share of dividends received. Further, 
the reserve deduction and other deductible payments to policyhold- 
ers of a life insurance company are reduced by the policyholders' 
share of tax exempt interest. Moreover, in the case of a property 
and casualty insurance company, 15 percent of the sum of tax 
exempt interest and the deductible portion of dividends received re- 
duces the deduction for losses incurred (section 832(b)(4)). 

Scope of expense allocation rules 

For purposes of subchapter N of chapter 1 of the Code (sees. 861- 
999), except as provided in regulations, the Act provides a series of 
rules governing expense allocation and apportionment. The intent 
of the grant of regulatory authority was to allow regulations to 
identify provisions of this subchapter to which the new rules would 
not apply. The Act's rules literally apply for the determination of 
taxable income from sources outside the United States. With one 
exception, however, these rules were intended to apply for all de- 
terminations under subchapter N of chapter 1, whatever the source 
(U.S. or foreign) of the income against which expenses are allocat- 
ed. The exception relates to the possessions tax credit: Congress did 
not intend that new Code section 864(e)(1) apply for purposes of 
computations under section 936(h). 



187 

Transition rules 

The Act provides a number of transition rules designed to phase 
in the application of the new expense allocation rules insofar as 
they relate to interest expenses. 

Explanation of Provisions 
Basis of stock of nonaffiliated 10-percent owned corporations 

The bill clarifies the Act's rule governing the allocation and ap- 
portionment of expenses when the tax book value method is used 
and the asset at issue is stock in one of certain corporations. The 
adjusted basis of any stock in a nonaffiliated 10-percent owned cor- 
poration is increased by the amount of earnings and profits of that 
corporation attributable to that stock and accumulated during the 
period the taxpayer held the stock, or reduced, but not below zero, 
by any deficits in earnings and profits in that corporation attribut- 
able to that stock for that period. For this purpose, a "nonaffiliated 
10-percent owned corporation" is one that is not included in the 
taxpayer's affiliated group, and in which members of the affiliated 
group own 10 percent or more of the voting power. The bill makes 
it clear that the adjustment to asset value on a look-through basis 
is also applied to stock of foreign corporations that is not directly 
held by U.S. taxpayers but that is indirectly 10-percent owned by 
U.S. taxpayers. Stock owned directly or indirectly by a corporation, 
partnership, or trust is treated as being owned proportionately by 
its shareholders, partners or beneficiaries. When a taxpayer is 
treated under this look-through rule as owning stock in a lower 
tier corporation, the adjustment to the basis of the upper-tier cor- 
poration in which the taxpayer actually owns stock is to include an 
adjustment for the amount of the earnings and profits (or deficit in 
earnings and profits) of the lower-tier corporation which were at- 
tributable to the stock the taxpayer is treated as owning and to the 
period during which the taxpayer is treated as owning that stock. 

The bill provides that proper adjustment is to be made to the 
earnings and profits of any corporation to take into account any 
earnings and profits included in gross income under the subpart F 
current inclusion rules (or under any other provision) that are re- 
flected in the adjusted basis of the stock. Thus, a subpart F inclu- 
sion, which increases stock basis but does not decrease earnings 
and profits of a controlled foreign corporation, is not to result in 
double counting. 

Allocation of expenses to deductible dividends 

The bill makes it clear that to the extent any dividend benefits 
from the dividends received deduction under section 243 (allowing 
an 80-percent dividends received deduction for certain dividends 
from U.S. corporations) or 245(a) (allowing an 80-percent dividends 
received deduction for the U.S. source portion of certain dividends 
from foreign corporations), that portion of the dividend is treated 
as tax exempt income for the purpose of the Act's expense alloca- 
tion rules and that portion of the related asset is treated as a tax 
exempt asset. 



188 

Treatment of bank holding companies and banks 

The bill provides that, to the extent provided in regulations, a 
bank holding company (within the meaning of section 2(a) of the 
Bank Holding Company Act of 1956), and any subsidiary of a bank 
holding company predominantly engaged in the active conduct of a 
banking, financing, or similar business, shall be treated as a finan- 
cial institution for the exception that applies in certain cases to fi- 
nancial institutions described in section 581 or 591. The bill also 
makes it clear that any financial institution that is excluded from 
the general one-taxpayer group and is included in a one-taxpayer 
group covering financial institutions is not so treated for purposes 
of expenses other than interest. That is, financial institutions and 
all other affiliated entities are treated as one taxpayer under the 
Act for expenses other than interest. 

Direct allocation of interest expense when deduction is denied 

The bill provides that the Secretary is to prescribe regulations 
for direct allocation of interest expense in the case of indebtedness 
resulting in a disallowance under section 246A, which reduces the 
dividends received deduction in cases where portfolio stock is debt 
financed. Thus, to the extent that an interest deduction reduces the 
amount of the dividends received deduction, the interest expense 
generating the loss of the dividends received deduction is to be 
treated as directly allocable to the income resulting from the loss 
of the dividends received deduction. 

Under the bill, the Secretary is also to prescribe regulations pro- 
viding that, in the case of an life insurance company, the Act's rule 
requiring that tax-exempt assets and income therefrom be disre- 
garded will not apply to the policyholders' share of any tax-exempt 
asset or income from such an asset. That is, the policyholders' 
share of assets that produce tax-exempt income will attract ex- 
penses notwithstanding their tax-exempt character. The same 
treatment applies to tax-exempt assets of property and casualty in- 
surance companies, to the extent that the income from such assets 
reduces that company's loss deduction (under section 832(b)(4)). 

In general, similar treatment is to apply with respect to the pol- 
icyholder's share of stock that insurance companies hold to the 
extent that dividends it pays would be eligible for the 80-percent 
dividends received deduction. Thus, that stock will attract expenses 
notwithstanding the deduction for the dividends it would pay. 

Scope of expense allocation rules 

The bill provides that new Code section 864(e) (relating to ex- 
pense allocation) shall not apply for purposes of any provision of 
subchapter N of chapter 1 of the Code (sees. 861-999) to the extent 
the Secretary determines under regulations that the application of 
this subsection for such purposes would not be appropriate. In a 
conforming amendment, the bill deletes the provision for excep- 
tions to new Code section 864(e) in the introductory language to 
that subsection. 

With one exception, the bill makes it clear that these rules apply 
for all determinations under subchapter N of chapter 1, whatever 
the source of the income against which expenses are allocated. The 



189 

exception relates to the possessions tax credit: Code section 936(h) 
is to apply as if new Code section 864(e)(1) had not been enacted. 

Transition rules 

The bill clarifies the operation of the Act's transition rules. 

One set of the bill's provisions clarifies the Act's phase-in of the 
Act's new rules governing interest expense allocation generally. 
(This set of the bill's provisions does not affect the Act's phase-in of 
the one-taxpayer rule of new Code sec. 864(e)(1), which is described 
below.) 'These clarifications, the bill's "general" phase-in provisions, 
apply to the aggregate amount of indebtedness of the taxpayer out- 
standing on November 16, 1985. In the case of the first three tax- 
able years of the taxpayer beginning after December 31, 1986, the 
Act's amendments relating to interest expense allocation (other 
than the one-taxpayer rule of new Code sec. 864(e)(1)) do not apply 
to interest expenses paid or accrued by the taxpayer during the 
taxable year with respect to an aggregate amount of indebtedness 
which does not exceed the general phase-in amount. Except for cer- 
tain reductions in indebtedness, the consequences of which are de- 
scribed below, the general phase-in amount is the applicable per- 
centage of the taxpayer's debt outstanding on November 16, 1985. 
In the case of the first taxable year, the applicable percentage is 
75; in the case of the second taxable year, the applicable percent- 
age is 50; in the case of the third taxable year, the applicable per- 
centage is 25. 

The general phase-in amount eligible for relief for any period, 
however, is not to exceed the lowest amount of indebtedness of the 
taxpayer outstanding as of the close of any preceding month begin- 
ning after November 16, 1985. To the extent provided in regula- 
tions, the average amount of indebtedness outstanding during any 
month is to be used in lieu of the amount outstanding as of the 
close of such month for this purpose. This grant of regulatory au- 
thority is designed to allow the Internal Revenue Service to disal- 
low transition relief to taxpayers whose month-end debt levels are 
not representative of their monthly debt levels generally. Reduc- 
tions in debt as of a month's end are not to reduce phase-in relief 
for prior months, however. For example, if a calendar year taxpay- 
er's outstanding debt is $100 on November 16, 1985 and at all times 
thereafter until December 1, 1987, at which time it pays off all its 
debt, the taxpayer is entitled to general phase-in treatment for in- 
terest on $75 during the first 11 months of 1987. 

In addition, the bill's "special" phase-in rules clarify the Act's 
provisions that phase in the Act's one-taxpayer rule (new Code sec. 
864(e)(1)). In the case of the taxpayer's first five taxable years be- 
ginning after December 31, 1986, the Code's new one-taxpayer rule 
(Code sec. 864(e)(1)) is not to apply to interest expenses paid or ac- 
crued by the taxpayer during the taxable year with respect to an 
aggregate amount of indebtedness that does not exceed the special 
phase-in amount. The special phase-in amount is the sum of three 
separate amounts: the general phase-in amount, described above, 
the five-year phase-in amount, and the four-year phase-in amount. 

The five-year phase-in amount is the lesser of two amounts. The 
first amount is an applicable percentage of the "5-year base." The 
5-year base is the the excess (if any) of the amount of a taxpayer's 



190 

outstanding indebtedness on May 29, 1985, over the amount of the 
taxpayer's outstanding indebtedness as of the close of December 31, 
1983. For this purpose, however, the 5-year base cannot exceed the 
aggregate amount of indebtedness of the taxpayer outstanding on 
November 16, 1985. The applicable percentage, in each year, is the 
excess of the percentage granted relief under the Act's 5-year 
phase-in over the percentage granted relief under the Act's general 
(3-year) phase-in. In the case of the first taxable year beginning 
after December 31, 1986, the applicable percentage is 8-1/3 (83-1/3 - 
75); in the case of the second taxable year, the applicable percent- 
age is 16-2/3 (66-2/3 — 50); in the case of the third taxable year, 
the applicable percentage is 25 (50 — 25); in the case of the fourth 
taxable year, the applicable percentage is 33-1/3; and in the case of 
the fifth taxable year, the applicable percentage is 16-2/3. 

The 5-year phase-in amount cannot exceed a second amount. 
That second amount, which is in the nature of a limitation, caps 
the 5-year phase-in amount in cases where reductions of indebted- 
ness ("paydowns") reduce the taxpayer's debt below the amount 
that would have been eligible for 5-year relief had no paydown oc- 
curred. More specifically, the second amount is the 5-year base, re- 
duced (but not below zero) by paydowns of debt, and then multi- 
plied by a percentage. The paydowns that reduce the 5-year base 
for this purpose are defined as the excess of the taxpayer s Novem- 
ber 16, 1985, debt over the lowest amount of indebtedness of the 
taxpayer outstanding as of the close of any preceding month begin- 
ning after November 16, 1985 (or to the extent provided in regula- 
tions, as under the general phase-in, the average amount of indebt- 
edness outstanding during any such month). 

To compute this second amount, the (possibly reduced) 5-year 
base is multiplied by a fraction the numerator of which is the ap- 
plicable 5-year percentage (the excess of the 5-year percentage 
under present law over the 3-year percentage), and the denomina- 
tor of which is the sum of the applicable percentage under the gen- 
eral (3-year) rule and the applicable percentage under the 5-year 
rule. This second amount limits the 5-year base only in cases where 
paydowns reduce the amount of the 5-year base below the amount 
of relief that would be granted if no paydown had occurred. In the 
case of the first taxable year beginning after December 31, 1986, 
this percentage is 10, i.e., 8-1/3 divided by the sum of 8-1/3 and 75; 
in the case of the second taxable year, this percentage is 25, i.e., 16- 
2/3 divided by the sum of 50 and 16-2/3; in the case of the third 
taxable year, this percentage is 50, i.e., 25 divided by 50; in the case 
of the fourth taxable year, this percentage is 100, i.e., 33-1/3 divid- 
ed by 33-1/3; and in the case of the fifth taxable year, this percent- 
age is 100, i.e., 16-2/3 divided by 16-2/3. 

This second amount preserves the full 5-year benefit in cases 
where the taxpayer's lowest debt is equal to or greater than the 
product of the 5-year base (unreduced by paydowns) and Act's 5- 
year percentage. (The Act's 5-year percentage is restructured under 
the bill as the sum of two applicable percentages: the applicable 
percentage for the purpose of the general (3-year) rule and the add- 
on applicable percentage for the purpose of the 5-year rule.) If pay- 
downs have reduced outstanding debt below the amounts that 
would have obtained full benefit under the 5-year rule had no pay- 



191 

downs occurred, this second amount reduces the 5-year benefit on a 
hnear basis. 

The 4-year phase-in amount is the lesser of two amounts. These 
amounts parallel the principles set forth above in connection with 
the 5-year amounts. The first amount is the applicable percentage 
of the "4-year base." The 4-year base is the the excess (if any) of 
the amount taxpayer's outstanding indebtedness on December 31, 
1983, over the amount of the taxpayer's outstanding indebtedness 
as of the close of December 31, 1982. For this purpose, however, the 
4-year base cannot exceed the excess of the aggregate amount of in- 
debtedness of the taxpayer outstanding on November 16, 1985 over 
the 5-year base. The applicable percentage, in each year, is the 
excess of the percentage granted relief under the Act's 4-year 
phase-in over the percentage granted relief under the Act's general 
(3-year) phase-in. In the case of the first taxable year beginning 
after December 31, 1986, the applicable percentage is 5 (80 - 75); in 
the case of the second taxable year, the applicable percentage is 10 
(60 — 50); in the case of the third taxable year, the applicable per- 
centage is 15 (40 - 25); and in the case of the fourth taxable year, 
the applicable percentage is 20. 

The 4-year phase-in amount cannot exceed a second amount. 
That second amount is intended to reduce the 4-year phase-in 
amount to the extent that paydowns reduce the taxpayer's debt 
below the amount that would be eligible for 4-year relief had no 
paydown occurred. More specifically, the second amount is the 4- 
year base, reduced (but not below zero) by certain paydowns of 
debt, multiplied by a percentage. The paydowns that reduce the 4- 
year base for this purpose are generally defined as the excess of 
the taxpayer's November 16, 1985, debt, over the lowest amount of 
indebtedness of the taxpayer outstanding as of the close of any pre- 
ceding month beginning after November 16, 1985 (or to the extent 
provided in regulations, as under the general phase-in, the average 
amount of indebtedness outstanding during any such month). This 
paydown amount for 4-year purposes is reduced, but not below 
zero, by the amount of the 5-year base. 

For purposes of this second amount, the (possibly reduced) 4-year 
base is multiplied by a fraction the numerator of which is the per- 
centage added to general relief under the 4-year rule and the de- 
nominator of which is the percentage granted relief after the appli- 
cation of both the 4-year rule and the general (3-year) relief. In the 
case of the first taxable year beginning after December 31, 1986, 
this percentage is 6.25, i.e., 5 divided by (5 + 75); in the case of the 
second taxable year, this percentage is 16-2/3, i.e., 10 divided by 60; 
in the case of the third taxable year, this percentage is 37.50, i.e., 
15 divided by 40; and in the case of the fourth taxable year, this 
percentage is 100, i.e., 20 divided by 20. 

The bill provides that, to the extent possible, the general and 
special phase-in rules are to apply to the same amount of indebted- 
ness. 

The bill clarifies that amounts eligible for relief under the Act's 
phase-in rules are determined on the basis of indebtedness rather 
than interest expense. The bill is not intended to require that spe- 
cific interest expense be traced to specific indebtedness. 



192 

The following examples involve the application of the special 
phase-in rule for one-taxpayer treatment and the general phase-in 
rule for the Act's other interest expense allocation rules. 

Example 1 '~^' ' 

A U.S. parent company, a calendar year taxpayer, had outstand- 
ing third party interest-bearing debt of $50 from 1980 until Decem- 
ber 31, 1982. On July 1, 1983, the taxpayer's third party interest- 
bearing debt increased to $70. On July 1, 1984, the taxpayer's third 
party interest-bearing debt increased to $100. All this debt bore 
and bears annual interest at the same interest rate. 

The U.S. parent corporation's third party debt is $100 on Novem- 
ber 16, 1985, and at all relevant times thereafter. 

The general transition rule prevents application of any of the 
Act's interest expense allocation rules (other than the one-taxpayer 
rule of Code sec. 864(e)(1)) to interest on 75 percent of $100, the No- 
vember 16, 1985 amount. That is, the new rules (other than the 
one-taxpayer rule of Code sec. 864(e)(1), discussed below) cannot 
apply to interest on $75 of debt. The bill's limitation on the general 
phase-in amount does not affect this result because the taxpayer's 
debt level has not dipped below the amount otherwise eligible for 
general phase-in treatment, i.e., $75. 

The special phase-in rule, which governs the application of the 
one-taxpayer rule of Code sec. 864(e)(1), operates as follows. The 
special phase-in amount, that is, the amount eligible for special 
phase-in treatment is the sum of the general phase-in amount (de- 
termined above to be $75) and the 5- and 4-year amounts. 

The 5-year phase-in amount is the lesser of two amounts. The 
first amount is the applicable percentage of the "5-year base." The 
5-year base is $30, the excess of $100, the amount of the taxpayer's 
outstanding indebtedness on May 29, 1985, over $70, the amount of 
the taxpayer's outstanding indebtedness as of the close of Decem- 
ber 31, 1983. The applicable percentage, in the first taxable year 
beginning after December 31, 1986, is 8-1/3. Thus, the first amount 
is $2.50, that is, 8-1/3 percent of $30. 

The 5-year phase-in amount cannot exceed a second amount. In 
the case of the first taxable year beginning after December 31, 
1986, that second amount is the 5-year base, $30, unaffected here 
by paydowns of debt since none have occurred, and then multiplied 
by 10 percent, i.e., 8-1/3 divided by the sum of 8-1/3 and 75. Thus, 
the second amount is $3 ($30 multiplied by 10 percent). 

In this case, the 5-year amount is thus $2.50, the lesser of $2.50 
and $3. 

The 4-year phase-in amount is the lesser of two amounts. The 
first amount is the applicable percentage of the "4-year base." The 
4-year base is $20, the excess of $70, the amount of the taxpayer's 
outstanding indebtedness on December 31, 1983, over $50, the 
amount of the taxpayer's outstanding indebtedness as of the close 
of December 31, 1982. The applicable percentage, in the first tax- 
able year beginning after December 31, 1986, is 5. Thus, the first 
amount is $1, that is, 5 percent of $20. 

The 4-year phase-in amount cannot exceed a second amount. In 
the case of the first taxable year beginning after December 31, 
1986, that second amount is the 4-year base, $20, unaffected here 



193 

by paydowns of debt since none have occurred, and then multiplied 
by 6.25 percent, i.e., 5 divided by the sum of 5 and 75. Thus, the 
second amount is $1.25 ($20 multiplied by 6.25 percent). 

In this case, the 4-year amount is thus $1, the lesser of $1 and 
$1.25. 

Thus, in this example, the amount of debt qualifying for one-tax- 
payer treatment is $78.50, which is the sum of $75, the general 
phase-in amount; $2.50, the 5-year phase-in amount; and $1, the 4- 
year phase-in amount. In this example, then, since the indebted- 
ness to which the general phase-in applies is to be, to the extent 
possible, the same indebtedness to which the special phase-in ap- 
plies, interest expense on $75 of debt is to be allocated under old 
law, interest expense on $3.50 of debt is to be allocated without use 
of the one-taxpayer rule but with use of the Act's other rules gov- 
erning interest allocation, and interest on $21.50 is to be appor- 
tioned under the Act's new rules. 

Example 2 

Assume the same facts as in the example above, except that the 
U.S. parent corporation's third party debt is $100 on November 16, 

1985, and until January 1, 1987, at which time it pays its debt 
down to $85. Its debt remains $85 at all relevant times thereafter. 

Again, the general transition rule prevents application of any of 
the Act's interest expense allocation rules (other than the one-tax- 
payer rule of Code sec. 864(e)(1)) to interest on $75. That is, the new 
rules (other than the one-taxpayer rule of Code sec. 864(e)(1), dis- 
cussed below) cannot apply to interest on $75 of debt. The bill's lim- 
itation on the general phase-in amount does not affect this result 
because the taxpayer's lowest debt level, $85, has not dipped below 
the amount otherwise eligible for general phase-in treatment, i.e., 
$75. 

The special phase-in rule, which governs the application of the 
one-taxpayer rule of Code sec. 864(e)(1), operates as follows. The 
amount eligible for special phase-in treatment is the sum of the 
general phase-in amount (again determined above to be $75) and 
the 5- and 4-year amounts. 

The 5-year phase-in amount is the lesser of two amounts. The 
first amount is again $2.50, that is, 8-1/3 percent of $30. 

The 5-year phase-in amount cannot exceed a second amount. In 
the case of the first taxable year beginning after December 31, 

1986, that second amount is the 5-year base, $30, reduced by the 
$15 paydown of debt (representing the difference between the No- 
vember 16, 1985, amount and the $85 lowest monthly amount) to 
$15 and then multiplied by 10 percent. Thus, the second amount is 
$1.50 ($15 multiplied by 10 percent). 

In this case, the 5-year amount is thus $1.50, the lesser of $2.50 
and $1.50. 

The 4-year phase-in amount is again the lesser of two amounts. 
The first amount again is $1, that is, 5 percent of $20. 

The 4-year phase-in amount cannot exceed a second amount. In 
the case of the first taxable year beginning after December 31, 
1986, that second amount is the 4-year base, $20, subject to reduc- 
tion on account of the paydown of debt, multiplied by 6.25 percent. 
There is no reduction on account of paydowns in this example, be- 



194 

cause the $15 paydown for 4-year purposes is reduced, but not 
below zero, by the $30 amount of the 5-year base. Thus, the second 
amount is again $1.25 ($20 multipUed by 6.25 percent). 

In this case, the 4-year amount is thus $1, the lesser of $1 and 
$1.25. 

Thus, in this example, the amount of debt qualifying for one-tax- 
payer treatment is $77.50, which is the sum of $75, the general 
phase-in amount; $1.50, the 5-year phase-in amount; and $1, the 4- 
year phase-in amount. In this example, then, since the indebted- 
ness to which the general phase-in applies is to be, to the extent 
possible, the same indebtedness to which the special phase-in ap- 
plies, interest expense on $75 of debt is to be allocated under old 
law, interest expense on $2.50 of debt is to be allocated without use 
of the one-taxpayer rule but with use of the Act's other rules gov- 
erning interest allocation, and interest on $22.50 is to be appor- 
tioned under the Act's new rules. 

Example 3 

A third example assumes examines the third taxable year begin- 
ning after 1986, the calendar year 1989. In this example, the facts 
are the same as in the first two examples, except that the taxpayer 
paid its debt down to $80 on January 1, 1989. Its debt remains at 
$80 throughout 1989. 

The general transition rule prevents application of any of the 
Act's interest expense allocation rules (other than the one-taxpayer 
rule of Code sec. 864(e)(1)) to 25 percent of $100, the November 16, 
1985 amount. That is, the new rules (other than the one-taxpayer 
rule of Code sec. 864(e)(1), discussed below) cannot apply to interest 
on $25 of debt. The bill's limitation on the general phase-in amount 
does not affect this result because the taxpayer's debt level has not 
dipped below $25. 

The special phase-in rule, which governs the application of the 
one-taxpayer rule of Code sec. 864(e)(1), operates as follows. The 
amount eligible for special phase-in treatment is the sum of the 
general phase-in amount (determined above to be $25) and the 5- 
and 4-year amounts. 

The 5-year phase-in amount is the lesser of two amounts. The 
first amount is the applicable percentage (25) of the 5-year base 
($30). Thus, the first amount is $7.50, that is, 25 percent of $30. 

The 5-year phase-in amount cannot exceed a second amount. In 
the case of the third taxable year beginning after December 31, 
1986, that second amount is $5 (the 5-year base, $30, reduced by the 
$20 paydown) multiplied by 50 percent. Thus, the second amount is 
$5 ($10 multiplied by 50 percent). 

In this case, the 5-year amount is thus $5, the lesser of $7.50 and 
$5. 

The 4-year phase-in amount is the lesser of two amounts. The 
first amount is the applicable percentage for the third taxable year 
beginning after 1986 of the 4-year base ($20). The applicable per- 
centage, in the third taxable year beginning after December 31, 
1986, is 15. Thus, the first amount is $3, that is, 15 percent of $20. 

The 4-year phase-in amount cannot exceed a second amount. In 
the case of the third taxable year beginning after December 31, 
1986, that second amount is the 4-year base, $20, subject to reduc- 



195 

tion on account of the paydown of debt, multiplied by 37.5 percent. 
There is no reduction on account of paydowns in this example, be- 
cause the $20 paydown for 4-year purposes is reduced, but not 
below zero, by the $30 amount of the 5-year base. Thus, the second 
amount is $7.50 ($20 multiplied by 37.5 percent). 

In this case, the 4-year amount is thus $3, the lesser of $3 and 
$7.50. 

Thus, in this example, the amount of debt qualifying for one-tax- 
payer treatment is $33, which is the sum of $25, the general phase- 
in amount; $5, the 5-year phase-in amount; and $3, the 4-year 
phase-in amount. In this example, then, since the indebtedness to 
which the general phase-in applies is to be, to the extent possible, 
the same indebtedness to which the special phase-in applies, inter- 
est expense on $25 of debt is to be allocated under old law, interest 
expense on $8 of debt is to be allocated without use of the one-tax- 
payer rule but with use of the Act's other rules governing interest 
allocation, and interest on $67 is to be apportioned under the Act's 
new rules. 

The bill clarifies that for transition rule purposes, all members of 
an affiliated group of corporations are to be treated as one corpora- 
tion. Thus, the bill makes it clear that debt of all members is to be 
aggregated in determining if a paydown that reduces phase-in ben- 
efits has occurred. Similarly, the bill makes it clear that interest 
on interafflliate debt is not eligible for transition relief. 



C. U.S. Taxation of Income Earned Through Foreign Corpora- 
tions (sec. 112(h)-(k) of the bill, sees. 1023, 1221, and 1224-1226 
of the Reform Act, and sees. 245, 246A, 552, 861, 881, 901, and 
951-955 of the Code) 

1. Captive insurance companies 

Present Law 

Election to treat related person insurance income as effectively con- 
nected with a U.S. business 

Under subpart F of the Code, certain types of income of U.S.-con- 
trolled foreign corporations are included currently in shareholder 
income and taxed by the United States regardless of whether the 
income is actually distributed currently to shareholders. A taxpay- 
er is generally subject to income inclusion under subpart F only if 
the taxpayer is a "U.S. shareholder" in a "controlled foreign corpo- 
ration." Since the enactment of the subpart F rules in 1962, the 
term "U.S. shareholder" has generally been limited to those U.S. 
persons owning (directly, indirectly, or by attribution) 10 percent or 
more of a foreign corporation's combined voting power. The term 
"controlled foreign corporation" has generally been limited to 
those foreign corporations more than half of the stock of which is 
owned by U.S. shareholders (under the Act, more than half by vote 
or by value). 

The Act introduced new subpart F rules for taxing the income of 
so-called captive foreign insurance companies. Under the new 
rules, related person insurance income of these companies is cur- 
rently taxable to an expanded category of U.S. persons. The statute 
achieves this result first by treating as a "U.S. shareholder" any 
U.S. person who owns directly or indirectly any stock in a foreign 
corporation, whether or not it meets the 10 percent threshold; and 
second by lowering the U.S. shareholder ownership threshold for 
controlled foreign corporation status to 25 percent or more. These 
modifications apply only for purposes of taking into account related 
person insurance income under subpart F. 

The Act provides three exceptions to the new subpart F rules for 
captive insurers. Under one of these exceptions, a foreign corpora- 
tion may avoid the application of the new subpart F rules for cap- 
tives by electing to treat related person insurance income that 
would not otherwise be taxed on a net basis (as effectively connect- 
ed with a U.S. trade or business) as income that is effectively con- 
nected with a U.S. trade or business. The income deemed to be ef- 
fectively connected under this election will be excluded from sub- 
part F income. 

Congress intended the election to be available only to those cor- 
porations which are controlled foreign corporations solely by virtue 
of the new rules for captive insurers. The Act provides that the 

(196) 



197 

election is to be made at such time and in such manner as the Sec- 
retary may prescribe. The election is effective in the year made 
and in all future years. The election is not effective if the electing 
corporation fails to meet such requirements as the Secretary shall 
prescribe to ensure that the tax imposed on its related person in- 
surance income is paid. 

To make the election, the foreign corporation must waive all U.S. 
income tax treaty benefits with respect to its related person insur- 
ance income. Treaty benefits with respect to the branch profits tax 
newly created by the Act are irrelevant to income with respect to 
which the election is properly made, however, because the Act ex- 
cludes from the imposition of branch profits tax the earnings and 
profits attributable to income treated as effectively connected 
solely because of the election. 

Amount of subpart F inclusion 

When a controlled foreign corporation earns subpart F income, 
the United States generally taxes the corporation's U.S. sharehold- 
ers currently on their pro rata share of the subpart F income. Re- 
lated person insurance income (as defined by the Act) is a type of 
subpart F income. 

In the case of a corporation that is a controlled foreign corpora- 
tion for its entire taxable year, and a U.S. shareholder that owns 
the same proportion of stock in the corporation throughout the cor- 
poration's taxable year, the U.S. shareholder's pro rata share of 
subpart F income is the amount that would have been distributed 
with respect to the shareholder's stock if on the last day of the tax- 
able year the controlled foreign corporation had distributed all of 
its subpart F income pro rata to all of its shareholders. 

The pro rata share definition provides for adjustments where the 
corporation is a controlled foreign corporation for less than the 
entire year or where actual distributions are made with respect to 
stock the shareholder owns for less than the entire year. The latter 
adjustment, contained in section 951(a)(2)(B), reduces a U.S. share- 
holder's pro rata share by a fraction of the dividends distributed to 
any other person during the controlled foreign corporation's tax- 
able year on stock owned by the U.S. shareholder at year-end. The 
fraction equals the proportion of the taxable year during which the 
U.S. shareholder did not own the stock. 

Primary insureds 

The Act defines related person insurance income as any insur- 
ance income attributable to a policy of insurance or reinsurance 
with respect to which the primary insured is either a U.S. share- 
holder (as defined above) in the foreign corporation receiving the 
income or a person related to such a shareholder. 

It was Congress' intent that related person insurance income in- 
clude income attributable to policies of reinsurance issued by a for- 
eign corporation to its U.S. shareholders that previously insured 
the risks covered by such policies or to persons related to such 
shareholders that previously insured the risks covered by such poli- 
cies. In addition. Congress gave the Secretary authority under the 
Act to prevent the avoidance of the captive insurance rules 
through cross insurance arrangements or otherwise. 



198 

The new subpart F rules for captive insurers do not apply if less 
than 20 percent of the stock of the corporation (by vote or by value 
of both stock and policies) is owned (directly or indirectly) by per- 
sons who are the primary insureds under any policies of insurance 
or reinsurance issued by the corporation, or by persons related to 
such primary insureds. 

Gross insurance income 

Under a de minimis exception to the new subpart F rules for 
captive insurers, these rules do not apply to income of a foreign 
corporation whose related person insurance income for the taxable 
year is less than 20 percent of its insurance income for the year. 
Congress intended that this computation be performed on a gross 
basis. Insurance income is defined for this purpose as it is general- 
ly for subpart F purposes under the Act, except that the exclusion 
of income attributable to same-country risks does not apply. 

Definition of related person 

The application of the new captive insurance rules turns on the 
distinction between persons who are and are not related to U.S. 
shareholders (within the meaning of section 954(d)(3) as amended 
by the Act). A person is related to a controlled foreign corporation 
if the person controls, is controlled by, or is under common control 
with the controlled foreign corporation. 

Congress intended that related person insurance income include 
income attributable to officers' or directors' insurance where the 
U.S. shareholders of the foreign corporation receiving such income 
(or persons related to such shareholders) directly or indirectly pay 
the premiums and the insureds are officers or directors of the U.S. 
shareholders (or persons related to such shareholders). 

Definition of related person insurance income 

As stated above, the Act defines related person insurance income 
as a type of "insurance income." The Code provides special rules 
for computing tax haven insurance income. Section 953(b) states 
that for these purposes all items of income, expenses, losses, and 
deductions shall be properly allocated or apportioned under regula- 
tions prescribed by the Secretary. Section 953(b) also eliminates or 
limits the applicability of certain provisions of subchapter L of the 
Code ("Insurance Companies") for these purposes. Congress intend- 
ed that these special rules for computing tax haven insurance 
income apply in computing related person insurance income. 

Explanation of Provisions 

Election to treat related person insurance income as effectively con- 
nected with a U.S. business 

The bill supplements the Code provisions describing the election 
to treat related person insurance income as effectively connected 
with a U.S. trade or business in order to make it clear that the 
election is not available to a corporation that is a controlled foreign 
corporation without applying the special subpart F rules for cap- 
tive insurance companies, or that was a controlled foreign corpora- 
tion without regard to those rules for any pre-election taxable year 



199 

beginning after 1986. The bill further provides that if a corporation 
is entitled to make the election in one year, but in a later year be- 
comes a controlled foreign corporation as defined by the general 
subpart F rules, an election made for the earlier year shall not 
apply to any taxable year after the later year. Thus, the bill clari- 
fies that the election is available only in situations where a foreign 
corporation and its shareholders are subject to subpart F treatment 
by virtue of the Act's special captive insurance rules, and not 
where subpart F treatment results from application of the rules 
that are generally applicable outside the captive insurance context. 
The bill also provides that in making the election the foreign cor- 
poration must waive all benefits (other than benefits with respect 
to the branch profits and branch interest taxes newly imposed by 
the Act) under any treaties between the United States and any for- 
eign country. Thus, for example, tax benefits claimed under a 
friendship, commerce, and navigation treaty would have to be 
waived by a foreign corporation making the election. However, the 
bill clarifies that treaty benefits with respect to the branch taxes 
need not be waived with respect to related person insurance 
income when that income is effectively connected without regard to 
the election. 

Amount of subpart F inclusion 

The bill provides a special definition of "pro rata share" for pur- 
poses only of taking into account related person insurance income. 
For these purposes, the special pro rata share definition is the 
lesser of (i) the amount which would be determined under the 
usual subpart F definition of pro rata share if only related person 
insurance income were taken into account, if stock owned by U.S. 
shareholders on the last day of the taxable year were the only 
stock in the foreign corporation, and if only distributions received 
by U.S. shareholders were taken into account under section 
951(a)(2)(B); or (ii) the amount which would be determined under 
the usual subpart F definition of pro rata share if the entire earn- 
ings and profits of the corporation for the taxable year were sub- 
part F income. 

For example, assume that throughout the first taxable year of a 
foreign corporation C'C"), 50 percent of the stock of C is owned by 
U.S. persons and the rest by foreign persons unrelated to U.S. per- 
sons. C's only activity is insuring risks of its U.S. shareholders and 
its foreign shareholders. During the taxable year exactly 50 per- 
cent of the income of C is related person insurance income and the 
earnings and profits of C for the year are twice C's related person 
insurance income for the year. Assume that C has no U.S. tax li- 
ability, that C has no other subpart F income for the taxable year, 
and that it does not distribute any of its earnings or invest in U.S. 
property during the year. 

Under the Act's new rules for captives, all U.S. persons that own 
stock in C are U.S. shareholders. Under the ordinary subpart F 
rules for computing their income inclusions, they would be treated 
as if C distributed to them half of its related person insurance 
income. This portion of C's related person insurance income would 
be taxed to the U.S. shareholders; the rest of C's related person in- 
surance income would not be taxed currently by the United States. 



200 

Under the bill, by contrast, the U.S. shareholders are taxed cur- 
rently on all of C's related person insurance income. 

Thus, the effect of the bill's special pro rata share definition is to 
ensure that if related person insurance income of a controlled for- 
eign corporation is at all currently taxable to U.S. shareholders 
under subpart F, then the full amount of the controlled foreign cor- 
poration's related person insurance income will be currently tax- 
able, up to the U.S. shareholders' proportionate share of the con- 
trolled foreign corporation's earnings and profits. Partial owner- 
ship of the corporation by foreign persons will not reduce the por- 
tion of the corporation's related person insurance income that is 
currently taxable to the U.S. shareholders (assuming the controlled 
foreign corporation has sufficient earnings and profits). As used in 
the bill's special pro rata share definition, the term "U.S. share- 
holder" has the meaning that it has when taking into account re- 
lated person insurance income: i.e., as modified by section 
953(c)(1)(a) (which dispenses with the 10 percent threshold). 

The bill further provides the Secretary with authority to modify 
the other rules of subpart F where necessary to permit an appro- 
priate computation of pro rata share under the bill's special rule. 
For example, it may be necessary or appropriate for the Secretary 
to coordinate this rule with the general pro rata share definition 
where the controlled foreign corporation has other types of subpart 
F income; or regulations may be appropriate for determining how 
the various types of subpart F income are to be reduced to account 
for the earnings and profits limitation on subpart F income. 

Primary insureds 

The bill eliminates the word "primary" from the references to 
"primary insureds" in the definition of related person insurance 
income and in the exception from the special captive insurance 
rules for corporations less than 20 percent of whose owners are in- 
sureds or related to insureds. Thus the bill clarifies that these ref- 
erences are intended to cover policies of reinsurance issued to U.S. 
shareholders and related persons, regardless of whether the con- 
tracts being reinsured were issued to unrelated persons. The Secre- 
tary retains regulatory authority to extend related person insur- 
ance income treatment to income from reinsurance issued to unre- 
lated parties, in those cases where doing so is necessary to prevent 
the avoidance of the captive insurer rules. 

Gross insurance income 

The bill clarifies that for purposes of applying the de minimis ex- 
ception to the captive insurance rules, comparison of a foreign cor- 
poration's related person insurance income to its insurance income 
is made on a gross basis. Thus, the de minimis rule is applied with- 
out regard to the relative profitability of the foreign corporation's 
related person insurance income, on the one hand, and its total in- 
surance income, on the other. 

Definition of related person 

The bill modifies the definition of related person for purposes of 
the captive insurance rules, making it clear that in the case of any 
insurance policy covering liability arising from services performed 



201 

as a director, officer, or employee of a corporation or as a partner 
or employee of a partnership, the person performing the services 
and the entity for which the services are performed will be treated 
as related persons. (As discussed below, the bill also raises the con- 
trol threshold for related person status generally from 50 percent 
to more than 50 percent.) 

Definition of related person insurance income 

The bill refines the definition of related person insurance income 
so that it specifically refers to insurance income as that term is de- 
fined in section 953(a), thus incorporating the special rules set forth 
in 953(b) for computing tay haven insurance income. 

2. Insurance companies in general 

Present Law 

Fresh start for computing discounted unpaid losses 

To take partial account of the time value of money, the Act 
amends subchapter L of the Code to provide for the discounting of 
the deduction for loss reserves of property and casualty insurance 
companies. Thus, the Act limits the deduction for unpaid losses to 
the amount of discounted unpaid losses (new sec. 846 of the Code). 

In general, the new discounting provisions apply to taxable years 
beginning after December 31, 1986. A fresh start is provided with 
respect to undiscounted loss reserves applicable to the last taxable 
year beginning before January 1, 1987. Under this fresh start rule, 
the difference between the amount of undiscounted loss reserves 
and the discounted balances is not taken into income. 

The Act provides that the fresh start adjustment is to be taken 
into account in full in the first taxable year to which the discount- 
ing provisions apply (generally, taxable years beginning in 1987) for 
purposes of calculating any adjustment to earnings and profits. The 
current earnings and profits of a controlled foreign corporation 
serve as a limitation on the amount of the corporation's subpart F 
income for the current taxable year. 

Definition of United States risk 

Section 861(a)(7) (unchanged by the Act) treats as U.S. source 
income amounts received as underwriting income derived from the 
insurance of U.S. risks as defined in section 953(a). Prior to the 
Act, section 953(a) defined the term "income derived from the in- 
surance of U.S. risks" as income that would (subject to certain 
modifications described in section 953(b)) be taxed under subchap- 
ter L if the income were that of a domestic insurance company, 
and that is attributable to the reinsurance or the issuing of any in- 
surance or annuity contract (1) in connection with property, activi- 
ties, or the lives or health of individuals resident in the United 
States, or (2) under any arrangement where another corporation 
receives a substantially equal amount for covering such risks. 

In connection with the Act's expansion of the subpart F tax 
haven insurance definition, extending current taxation to any 
income attributable to the issuing (or reinsuring) of any insurance 
or annuity contract in connection with risks in a country other 



202 

than that in which the insurer is created or organized, the defini- 
tion of U.S. risk was no longer relevant for section 953(a) purposes. 
Congress did not intend to alter the substance of the related source 
rule in section 861(a)(7). 

Explanation of Provision 
Fresh start for computing discounted unpaid losses 

The bill provides that for purposes of computing the earnings 
and profits limitation on subpart F income, current earnings and 
profits are determined without regard to the increase in current 
earnings and profits under the discounting fresh start provision of 
the Act. Thus, the one-time increase in current earnings and prof- 
its of a controlled foreign corporation under the discounting fresh 
start provision will not result in any increase in subpart F income 
of that corporation. 

Definition of United States risk 

The bill reinstates for purposes of 861(a)(7) the pre-Act definition 
of income from U.S. risks. The bill treats as U.S. source income 
amounts received as underwriting income derived from the issuing 
(or reinsuring) of any insurance or annuity contract (1) in connec- 
tion with property, activities, or the lives or health of individuals 
resident in the United States, or (2) under any arrangement where 
another corporation receives a substantially equal amount for cov- 
ering such risks. 

3. Withdrawals of qualified shipping reinvestments that pre-Act 
law excluded from subpart F income 

Present Law 

The Act repealed the rule that, under prior law, excluded from 
subpart F income foreign base company shipping income that was 
reinvested in foreign base company shipping operations. This 
change was not intended to modify the taxation of withdrawals 
(whether by disposition of assets, adjustments to basis, or other- 
wise) of previously excluded subpart F income from qualified ship- 
ping reinvestments. Under the Act, the withdrawal from qualified 
investment for a particular taxable year is measured by reference 
to the excess of qualified investments as of the close of the last tax- 
able year beginning before 1987 over the qualified investments at 
the close of the subsequent taxable year. 

Explanation of Provision 

The bill makes it clear that withdrawals of previously excluded 
subpart F income from qualified shipping reinvestments are to be 
taxed only once. For any taxable year beginning after 1986, the 
amount of withdrawal from qualified shipping investments for that 
year is limited by the bill to the excess (if any) of (1) the amount of 
pre-1987 qualified investments then remaining after the decreases 
in qualified investments determined for prior taxable years begin- 
ning after 1986, over (2) qualified shipping investments at year-end. 
Under this rule, post-1986 investments that meet the definition of 



203 

qualified investments in foreign base company shipping operations 
will delay the taxation of withdrawals until all such post-1986 in- 
vestments are withdrawn. 

4. Definition of related person 

Present Law 

Whether a controlled foreign corporation's income is subject to 
subpart F will depend in certain cases on whether the income is 
received from a related person. Generally, for example, dividends, 
interest, royalties, and rents are subpart F income. However, rents 
and royalties, for example, may be excluded from subpart F income 
if derived in the active conduct of a trade or business and received 
from a person other than a related person (sec. 954(c)(2)(A)). As an- 
other example, dividends and interest may be excluded if received 
from certain related persons organized under the laws of the same 
country as the controlled foreign corporation (sec. 954(c)(3)(A)(i)). 

A related person is one which controls, is controlled by, or is 
under common control with the controlled foreign corporation. The 
Act amended the definition of control for this purpose. In the case 
of a corporation, control means the direct or indirect ownership of 
50 percent or more of the total combined voting power of all classes 
of stock entitled to vote or of the total value of such corporation. In 
the case of a partnership, trust, or estate, control is defined as 
direct or indirect ownership of 50 percent or more of the total 
value of the beneficial interests in the entity. 

Whether income is subject to the separate foreign tax credit limi- 
tation for passive income may also turn on whether it is received 
from a related person. The definition of the passive income basket 
is generally based on the definition of foreign personal holding 
income under subpart F, which in turn uses the concept of "related 
person" to provide certain exceptions from foreign personal holding 
company income, such as rents and royalties derived in an active 
business, and certain same-country dividends and interest. In addi- 
tion, if a corporation is a controlled foreign corporation, payments 
that it makes to its U.S. shareholders may be characterized for pur- 
poses of the foreign tax credit baskets by reference to the character 
of the income of the controlled foreign corporation. 

In contrast to the definition of control for purposes of defining a 
related person, the Code treats a foreign corporation as a con- 
trolled foreign corporation only if more than 50 percent of its stock 
(by vote or value) is owned (directly, indirectly, or by attribution) 
by U.S. shareholders. Prior to the Act, the ownership threshold for 
related party status was, similarly, more than 50 percent of the 
total combined voting power of a corporation's voting stock. 

Different thresholds for defining "control" in the definitions of 
controlled foreign corporation, on the one hand, and related person, 
on the other, may produce unintended anomalies in the operation 
of the foreign tax credit limitation baskets, especially where look- 
through treatment may be involved. For example, assume that a 
foreign corporation owned 50-50 by two unrelated persons, one for- 
eign and one U.S., derives all of its income from manufacturing, 
and that it pays royalties to its U.S. shareholder, which derives the 
royalties in the active conduct of its trade or business. This income 



204 

of the shareholder is ineligible for the active royalty exception 
from foreign personal holding company income because the payor 
is a "related person." However, the foreign corporation is not a 
controlled foreign corporation, and therefore the royalty income of 
the shareholder cannot be recharacterized under the look-through 
to reflect the overall limitation character of the foreign corpora- 
tion's income. Thus, the royalty is passive basket income of the 
shareholder, even though it would not have been if the U.S. share- 
holder owned either more or less than 50 percent of the foreign 
corporation's stock. 

Explanation of Provision 

The bill provides that control, for purposes of the related person 
definition of section 954(d)(3), means direct or indirect ownership of 
more than 50 percent (by vote or value) of the stock of a corpora- 
tion or more than 50 percent (by value) of the beneficial interests 
in a partnership, trust or estate. Therefore, as was true prior to the 
Act, the definitions of both controlled foreign corporation and relat- 
ed person under subpart F are keyed to the same definition of cor- 
porate control. 

In the case of royalties derived in the active conduct of a trade or 
business, for example, the bill prevents treatment of a 50-percent 
U.S.-owned foreign corporation in a manner which is different than 
the treatment of both foreign corporations owned more than 50 
percent by U.S. persons and foreign corporations owned less than 
50 percent by U.S. persons. The bill eliminates, by contrast, the op- 
portunity for a controlled foreign corporation to exclude from for- 
eign personal holding company income, under section 954(c)(3)(A)(i), 
same-country dividends from a 50-percent owned foreign corpora- 
tion. 

5. Measurement of earnings and profits 

Present Law 

As noted above, the amount of earnings and profits of a con- 
trolled foreign corporation for a taxable year serves as a limitation 
on the amount of its subpart F income for the year. Except as pro- 
vided in section 312(k)(4), for purposes of subpart F the earnings 
and profits (or deficit in earnings and profits) of any foreign corpo- 
ration for any taxable year generally is determined according to 
rules substantially similar to those applicable to domestic corpora- 
tions, subject to regulations. 

The Tax Reform Act of 1984 introduced several provisions to 
make a corporation's earnings and profits more closely conform to 
its economic income where economic income diverged from taxable 
income. Under the 1984 Act, for example, a corporation using the 
LIFO method of accounting for inventory adjusts earnings and 
profits under rules designed to eliminate the impact of LIFO on 
earnings and profits (current Code sec. 312(n)(4)). A corporation's 
earnings and profits for a year in which the corporation sells prop- 
erty on the installment basis generally are to be computed as if the 
corporation did not use the installment method to account for the 
installment sale (current Code sec. 312(n)(5)). 



205 

A corporation that accounts for income and expenses attributa- 
ble to a long-term contract on the completed contract method of ac- 
counting generally recognizes income and expense in the year in 
which the contract is completed. Under the 1984 Act, a corporation 
that accounts for income and expense on this method is required to 
compute earnings and profits as if it were accounting for income 
and expense attributable to long-term contracts on a percentage of 
completion basis (sec. 312(n)(6)). 

The effect of these provisions is generally to accelerate the inclu- 
sion of amounts in earnings and profits, reducing to some extent 
amounts of earnings and profits that can be treated as current 
earnings in future taxable years. In the case of a domestic corpora- 
tion computing taxable dividends, this reduction in subsequent 
years' current earnings and profits does not generally reduce the 
tax on amounts distributed in the subsequent year, because the dis- 
tribution of accumulated earnings is also taxed. 

In the case of computing the subpart F limitation, on the other 
hand, acceleration of earnings under these provisions generally has 
the effect of raising the subpart F limitation in an earlier year 
than the year in which those earnings would be included in taxable 
income of U.S. shareholders. 

The Act put new limits on the amounts by which prior year defi- 
cits in earnings and profits, or deficits in non-subpart F income, 
can be used to reduce subpart F inclusions (sec. 952(c)). Those provi- 
sions generally do not, however, provide for increasing the earnings 
and profits limitation by a prior year excess of earnings and profits 
over subpart F income, even if those earnings and profits relate to 
subpart F income categories. 

Explanation of Provision 

Under the bill, the earnings and profits limitation on subpart F 
income is to be determined without regard to the rules that accel- 
erate the recognition of earnings and profits from inventory assets 
accounted for under the LIFO method, from installment sales, and 
from contracts the income from which is accounted for under the 
completed contract method. By conforming the computation of 
earnings and profits for this purpose to the computation of taxable 
income, the bill ensures that subpart F income inclusions more 
closely match the controlled foreign corporation's taxable subpart 
F income. The bill thus reduces the possibility that tax haven 
income will go untaxed. 

The modification also provides, however, that under regulations, 
if the earnings and profits arising from the inventory assets, in- 
stallment sale, or completed contract are distributed prior to the 
year that they would otherwise be included in income (e.g., the 
year in which the installment receivable is collected or the contract 
is completed), those earnings are not to be included in income in 
the later year. This treatment may be necessary to eliminate the 
potential for those earnings to be taxed twice. 



206 

6. Effective date of accumulated earnings tax amendments 

Present Law 

The Act amended sections 535 and 545 to provide that the accu- 
mulated earnings tax and personal holding company tax applicable 
to a foreign corporation will be calculated by taking net capital 
gains into account when computing the net capital gain deduction 
only if they are effectively connected with the conduct of a U.S. 
trade or business, and only if they are not exempt by treaty from 
U.S. tax. Congress intended that the amendments apply to gains 
and losses realized on or after January 1, 1986, rather than only 
those gains and losses realized after March 1, 1986 as stated in the 
Act.i 

Explanation of Provision 

The bill amends the effective date of the Act's amendments to 
section 535 and 545. Under the bill the Act's amendments apply to 
gains and losses realized on or after January 1, 1986. 

7. Dividends received deduction 

Present Law 

The Act rewrote section 245(a), which governs the deduction for 
dividends received from foreign corporations, modifying it in sever- 
al important respects. Under the Act, dividends eligible for the de- 
duction are based on the ratio of (a) the foreign corporation's post- 
1986 earnings and profits that have been subject to net-basis U.S. 
corporate income tax and that have not been distributed to (b) the 
corporation's total accumulated earnings and profits. 

Under Code section 1248, where a U.S. person sells or exchanges 
stock in a foreign corporation (or receives a distribution which is 
treated as an exchange of stock in a foreign corporation) which 
was, during the previous 5 years, a controlled foreign corporation 
in which the U.S. person was a U.S. shareholder, the gain recog- 
nized on the sale or exchange is treated as dividend income of the 
U.S. person to the extent of the earnings and profits of the foreign 
corporation attributable to such stock and accumulated since 1962 
during periods in which the corporation was a controlled foreign 
corporation and in which the U.S. person held the stock sold or ex- 
changed. For these purposes, certain income items, including gen- 
erally amounts effectively connected with a U.S. trade or business 
of the controlled foreign corporation and not exempt from tax (or 
subject to a reduced tax rate) by treaty, are excluded from earnings 
and profits. Thus, amounts treated as dividends under section 1248 
are generally derived from earnings not subject to U.S. corporate 
income tax, and therefore generally are not eligible for the divi- 
dends received deduction under the Act. 



1 See H. Rep. 99-841, Vol. II (September 18, 1986), p. 628 (Conference Report). 



207 

Explanation of Provision 

The bill provides that for purposes of section 245(a), the term div- 
idend does not include any amount treated as a dividend under sec- 
tion 1248. Thus, the bill clarifies that a taxpayer which is treated 
as having received dividend income due to the sale or exchange of 
stock in a controlled foreign corporation will not be eligible for a 
deduction of any portion of the amount treated as a dividend. 



D. Special Tax Provisions for U.S. Persons 

1. Effective date of provision governing transfers of intangibles to 
related parties (sec. 112(m) of the bill, sec. 1231 of the Reform 
Act, and sec. 482 of the Code) 

Present Law 

The Act requires that payments with respect to intangibles that 
a U.S. person transfers to a related foreign corporation or posses- 
sions corporation be commensurate with the income attributable to 
the intangible. The new provisions carrying out this rule apply to 
taxable years beginning after December 31, 1986, but only with re- 
spect to transfers after November 16, 1985, or licenses granted 
after that date (or before that date with respect to property not in 
existence or owned by the taxpayer on that date). For purposes of 
section 936, the new provisions apply to taxable years beginning 
after December 31, 1986, without regard to when any transfer (or 
license) was made. 

In view of the fact that the objective of these provisions — that 
the division of income between related parties reasonably reflect 
the relative economic activity undertaken by each — applies equally 
to inbound transfers, Congress concluded that it would be appropri- 
ate for these principles to apply to transfers between related par- 
ties generally (via Code sec. 482) if income must otherwise be taken 
into account. However, in the case of a transfer of the type that is 
covered by the Act but that would not have been affected by the 
House version of H.R. 3838, Congress intended to apply the above 
effective date provision substituting "August 16, 1986" for "Novem- 
ber 16, 1985." 

Explanation of Provision 

In the case of transfers and licenses of intangibles which are not 
to foreign persons (and not to possessions corporations), and there- 
fore not of the type affected by the House version of H.R. 3838, the 
bill modifies the relevant effective date provision of the Act. In the 
case of a transfer or license which is not to a foreign person or a 
possessions corporation, the bill provides that the Act applies to 
taxable years beginning after December 31, 1986, but only with re- 
spect to transfers after August 16, 1986, or licenses granted after 
that date (or before that date with respect to property not in exist- 
ence or owned by the taxpayer on that date). The bill clarifies that 
for purposes of section 936, which governs income from certain in- 
tangibles whether or not the intangibles are actually transferred, 
the Act's provisions apply to taxable years beginning after Decem- 
ber 31, 1986, regardless of whether a transfer (or license) was made. 

(208) 



209 

2. Treatment of certain passive foreign investment companies 
(sec. 112(n) of the bill, sec. 1235 of the Reform Act, and sees. 
904, 1246, 1248, 1291, 1293, 1294, 1296, and 1297 of the Code) 

Present Law 

Overview 

The Act established rules for passive foreign investment compa- 
nies (PFICs) and established separate rules for each of two types of 
PFICs. One set of rules applies to PFICs that are "qualified elect- 
ing funds," where each U.S. shareholder includes currently in gross 
income his or her share of a PFICs total earnings, with an election 
to defer payment of tax, subject to an interest charge, on income 
not currently received. The second set of rules applies to PFICs 
that are not qualified electing funds ("nonqualified funds"), whose 
U.S. shareholders pay tax on income realized from a PFIC and an 
interest charge which is attributable to the value of deferral. 

Definition of passive foreign investment company 

General definition 

A passive foreign investment company (PFIC) is any foreign cor- 
poration if 75 percent or more of its gross income for the taxable 
year consists of passive income, or any foreign corporation if 50 
percent or more of the average value of its assets consists of assets 
that produce, or are held for the production of, passive income. 
Passive income for these purposes means generally income that is 
includible in the passive income separate foreign tax credit limita- 
tion (Code sec. 904(d)(2)(A)), without regard to the exceptions con- 
tained therein (i.e., without regard to the exceptions to passive 
income for income included in other separate foreign tax credit 
limitations, export financing interest, high-taxed income, and for- 
eign oil and gas extraction income). Thus, for example, passive 
income does not include any dividend received by a corporation 
from a related corporation organized in the same foreign country 
as the shareholder if the dividend is excluded from passive income 
for foreign tax credit purposes. By incorporating the definition of 
passive income that is applied for foreign tax credit limitation pur- 
poses, the look-through rules contained therein {i.e., sees. 904(d)(3) 
and (d)(5)), are, to the extent applicable, applied in determining 
whether income is passive for PFIC purposes as well. 

Exceptions to PFIC classification 

Except as provided in regulations, passive income does not in- 
clude income derived by bona fide insurance companies that would 
be subject to taxation under subchapter L if the company were a 
U.S. corporation. It was intended that regulations provide that en- 
tities engaged in the business of providing insurance derive passive 
income and, thus, may be PFICs in certain cases where the entities 
maintain financial reserves in excess of the reasonable needs of 
their insurance business. 

In determining whether foreign corporations that own subsidiar- 
ies that are primarily engaged in active business operations are 
PFICs, look-through treatment is provided in certain cases. Under 



73-917 - 87 - 



210 

this look-through rule, a foreign corporation that owns at least 25 
percent of the stock of another corporation is treated as owning a 
proportionate part of the other corporation's assets and income. 
Thus, amounts such as interest and dividends received from foreign 
or domestic subsidiaries are eliminated from the shareholder's 
income in applying the income test and the stock or debt invest- 
ment is eliminated from the shareholder's assets in applying the 
asset test. It is unclear under the Act whether the look-through 
rule applies when the 25 percent ownership is indirectly held. 

General rule — nonqualified funds 

General rule 

United States shareholders in PFICs that are not "qualified 
electing funds" pay U.S. tax and an interest charge based on the 
value of tax deferral at the time the shareholder disposes of stock 
in the PFIC or on receipt of an "excess" distribution (Code sec. 
1291). Under this rule, gain recognized on disposition of stock in a 
PFIC or on receipt of an "excess" distribution from a PFIC is treat- 
ed as ordinary income and is considered as earned pro rata over 
the shareholder's holding period of his or her investment. Distribu- 
tions from nonqualified funds are not eligible for a deemed paid 
foreign tax credit under section 902. 

Definition of excess distribution 

An "excess" distribution is any current year distribution in re- 
spect of a share of stock that exceeds 125 percent of the average 
amount of distributions in respect of the share of stock received 
during the 3 preceding years (or, if shorter, the total number of 
years of the taxpayer's holding period prior to the current taxable 
year). It is unclear whether excess distributions are included in de- 
termining any 3-year average distribution amount in respect of a 
share of stock. 

Although the Act provided for certain adjustments in determin- 
ing the amount of an excess distribution, the Act did not provide 
any adjustment for amounts that may be currently included in 
income under other current inclusion rules. 

Anti-avoidance rules 

The Act, in addition to incorporating certain anti-avoidance rules 
in present law section 1246 (relating to foreign investment compa- 
nies), provided the Secretary the authority to disregard any nonrec- 
ognition provision of present law on dispositions of PFIC stock. For 
example, it is contemplated that regulations may treat a gift of 
stock in a nonqualified fund to a non-taxpaying entity, such as a 
charity or a foreign person, as a disposition for purposes of those 
rules in order that the deferred tax and interest charge attributa- 
ble to that stock not be eliminated. 

Qualified electing funds 

General rule 

United States persons who own stock in a "qualified electing 
fund" must include currently in gross income their pro rata share 



211 

of the PFIC's total earnings and profits. This inclusion rule re- 
quires current payment of tax, absent a shareholder-level election 
to defer tax. A qualified electing fund is any PFIC that properly 
elects with the Secretary and complies with the requirements the 
Secretary prescribes to determine the income of the PFIC, to ascer- 
tain its stock ownership, and to ascertain any other information 
necessary to carry out the purposes of those rules. 

The amount currently included in income is divided between a 
shareholder's pro rata share of the ordinary income of a PFIC and 
net capital gain income of a PFIC. The characterization of income, 
and the determination of earnings and profits, is made pursuant to 
general Code rules. Pro rata share of income is determined by ag- 
gregating a PFIC's income for the taxable year and attributing 
that income ratably over every day in the PFIC's year. United 
States persons then include in income for the period in which they 
hold stock in the PFIC their daily ownership interest in the PFIC 
multiplied by the amount of income attributed to each day. 

Election to defer current payment of tax 

United States investors in qualified electing funds may generally, 
subject to the payment of interest, elect to defer payment of U.S. 
tax on amounts currently included in income but for which no cur- 
rent distribution has been received. An election to defer tax is 
treated as an extension of time to pay tax for which a U.S. share- 
holder is liable for interest. 

Certain events cause an extension of time to pay tax on undis- 
tributed earnings to terminate. One of those events is the disposi- 
tion of stock in a PFIC, which terminates all previous extensions of 
time to pay tax with respect to the earnings attributable to that 
stock. It is intended that disposition for this purpose mean any 
transfer of ownership, regardless of whether the transfer consti- 
tutes a realization or recognition event under general Code rules. 
For example, a transfer at death or by gift of stock of a qualified 
electing fund is to be treated as a disposition for these purposes. 

Special rules applicable to both types of funds 

Coordination of section 1291 with taxation of shareholders in 
qualified electing funds 

Gain recognized on disposition of stock in a PFIC by a U.S. inves- 
tor is not taxed under section 1291 if the PFIC is a qualified elect- 
ing fund for each of the fund's taxable years which begin after De- 
cember 31, 1986 and which include any portion of the investor's 
holding period. 

Distributions received from a PFIC in a year the PFIC is a quali- 
fied electing fund are also intended not to be taxed under section 
1291 if the PFIC is a qualified electing fund for each of the fund's 
taxable years which begin after December 31, 1986, and which in- 
clude any portion of an investor's holding period. This provision 
prevents a fund from retaining its annual income, electing to be a 
qualified electing fund in a subsequent year, and then distributing 
the accumulated income without the imposition of an interest 
charge. 



212 

Attribution of ownership 

In determining stock ownership, a U.S. person is considered to 
own his proportionate share of the stock of a PFIC owned by any 
partnership, trust, or estate of which the person is a partner or 
beneficiary (or in certain cases, a grantor), or owned by any foreign 
corporation if the U.S. person owns 50 percent or more of the value 
of the corporation's stock. However, if a U.S. person owns any 
stock of a PFIC, the person is considered to own his proportionate 
share of any PFIC stock owned by the upper-tier PFIC, regardless 
of the percentage of his ownership in the upper-tier PFIC. In at- 
tributing stock ownership, holders of options for stock of a corpora- 
tion are not treated as owning the stock in the corporation. 

Anti-avoidance rules 

The Act provided authority to the Secretary to prescribe regula- 
tions that are necessary to carry out the purposes of the Act's pro- 
visions and to prevent circumvention of the interest charge. 

One example where regulations may be necessary to carry out 
the purposes of the Act's provisions is where the ownership attribu- 
tion rules attribute stock ownership in a PFIC to a U.S. person 
through an intervening entity and the U.S. person disposes of his 
interests in the intervening entity. In these cases, the intervening 
entity may not be a PFIC, so that the U.S. person could technically 
avoid the imposition of any interest charge. In this instance, regu- 
lations are intended to treat the disposition of interests in the in- 
tervening entity as a disposition of the PFIC stock. Similarly, if 
necessary to avoid circumvention of the Act's interest charge, it 
may be necessary under regulations to treat distributions received 
by an intervening entity as being received by the U.S. person. 

Coordination with other current inclusion and disposition 
rules 

The Act adopted rules to coordinate the PFIC provisions with the 
subpart F and FPHC current inclusion rules in the case of quali- 
fied electing funds. Under these coordination rules, amounts re- 
quired to be included in income currently under either section 951 
or 551 shall be included first under those rules and then any addi- 
tional amounts shall be included currently under section 1293. The 
Act did not provide coordination of the PFIC provisions and the 
subpart F and FPHC provisions for nonqualified funds. 

Explanation of Provision 
Definition of passive foreign investment company 

The bill makes it explicit that dividends received from certain re- 
lated corporations organized in the same country as the sharehold- 
er (namely, dividends described in sec. 954(c)(3)) are subject to look- 
through treatment in determining whether a corporation receives 
passive income. This conforms the treatment of these same country 
dividends to dividends received from other 25-percent (or more) 
owned corporations. 

The bill clarifies the exception from passive income for income 
received by bona fide insurance companies. This exception from 



213 

passive income extends only to income derived by insurance compa- 
nies that are predominantly engaged in the active conduct of an in- 
surance business and that would be taxed under the special rules 
applicable to domestic insurance companies if they were domestic 
corporations. Thus, income derived by entities engaged in the busi- 
ness of providing insurance will be passive income to the extent the 
entities maintain financial reserves in excess of the reasonable 
needs of their insurance business. 

The bill clarifies that the look-through rule for 25-percent-owned 
corporations applies to direct or indirect 25-percent ownership that 
is held by an upper-tier foreign corporation. 

The bill treats stock of certain U.S. corporations owned by an- 
other U.S. corporation which is at least 25-percent owned by a for- 
eign corporation as active assets. Under this rule, in determining 
whether a foreign corporation is a PFIC, stock of a regular domes- 
tic C corporation owned by a 25-percent owned domestic corpora- 
tion is treated as an asset which does not produce passive income 
(and is not held for the production of passive income), and income 
derived from that stock is treated as income which is not passive 
income. Thus, a foreign corporation, in applying the look-through 
rule available to 25-percent owned corporations, will be treated as 
owning non-passive assets in these cases. This rule does not apply, 
however, if, under a treaty obligation of the United States, the for- 
eign corporation is not subject to the accumulated earnings tax, 
unless the corporation agrees to waive any such benefit. This rule 
is designed to mitigate the potential disparate tax treatment be- 
tween U.S. individual shareholders who hold U.S. stock invest- 
ments through a U.S. holding company and those who hold those 
investments through a foreign holding company. If a foreign 
mutual fund attempts to use this rule to avoid the PFIC provisions, 
it will be subject to the accumulated earnings tax and, thus, will 
lose any potential U.S. tax benefits. 

Nonqualified funds 

The bill makes several modifications and clarifications to the 
rules applicable to PFICs that are not qualified electing funds. 

The bill eliminates the potential for double taxation by coordi- 
nating the nonqualified fund rules with the rules applicable to the 
Code's other current inclusion rules, the subpart F and the foreign 
personal holding company rules. Thus, for example, excess distribu- 
tions will not include any amounts that are treated as previously 
taxed income under section 959(a) distributed by a controlled for- 
eign corporation that is also a PFIC that is not a qualified electing 
fund. (Because items of previously taxed income increase a U.S. 
shareholder's stock basis to the extent those items are not distrib- 
uted (sec. 961), the deferred tax and interest charge rules of section 
1291 that apply to dispositions of stock in a PFIC that is not a 
qualified electing fund but that is a controlled foreign corporation 
are not affected by the above-described modifications.) 

The bill modifies the determination of an excess distribution to 
exclude from the 3-year average distribution amount that part of 
an excess distribution that is considered attributable to deferred 
earnings (i.e., that part of the excess distribution that is not alloca- 
ble to pre-PFIC years and to the current year). This modification is 



214 

necessary to prevent the avoidance of the interest charge that 
would otherwise be due on accumulated earnings. For example, a 
PFIC could accumulate earnings for a period of years, and then dis- 
tribute those earnings ratably over a period greater than three 
years. If the excess distributions received in the first three years 
were to be included in the 3-year average distribution amount, dis- 
tributions received after three years would not be excess distribu- 
tions, and hence no interest would be imposed on the deferred 
earnings inherent in those later distributions. 

The bill clarifies the determination of a taxpayer's holding 
period as it relates to receipt of an excess distribution. This clarifi- 
cation provides that a taxpayer's holding period is considered to 
end on the date of receipt of an excess distribution but only with 
respect to that distribution. Thus, the taxpayer's holding period in 
its stock to which the excess distribution is attributable does not 
end on the date of receipt of the excess distribution. 

The bill repeals the Act's provision which denies U.S. corporate 
shareholders in PFICs that are not qualified electing funds benefits 
of the indirect foreign tax credit under section 902. Thus, if a U.S. 
corporation owns at least 10 percent of the stock in a PFIC, the cor- 
poration is treated as paying its share of the PFICs foreign income 
taxes imposed on the earnings the PFIC distributes to the U.S. cor- 
poration. 

The bill also makes other clarifications to the Act's provisions 
applicable to PFICs that are not qualified electing funds. First, the 
bill clarifies that the deferred tax and interest charge rules of sec- 
tion 1291 do not apply to any distribution received by a taxpayer 
from a PFIC if the PFIC is a qualified electing fund for all of its 
years beginning after 1986 for which it is a PFIC and which in- 
clude any part of the taxpayer's holding period. This treatment 
parallels the rule for dispositions provided under the Act. Further, 
the bill clarifies that the regulatory authority provided under the 
Act to deny the benefits of any nonrecognition treatment extends 
to any transfers of PFIC stock, including transfers at death or by 
gift. 

Qualified electing funds 

The bill also modifies and clarifies the rules applicable to PFICs 
that are qualified electing funds. 

The bill provides that, to the extent provided in regulations, if a 
qualified electing fund establishes to the Secretary's satisfaction 
that it maintains records that determine investors' pro rata shares 
of income more accurately than allocating a taxable year's income 
ratably over a daily basis (for example, by allocating a month's 
income ratably over a daily basis), the fund can determine the in- 
vestors' pro rata shares of income on that basis. This provision is 
designed to allow those funds that maintain appropriate records to 
more accurately determine U.S. investors' pro rata shares of 
income in cases where the investors own their stock for only parts 
of a year. For example, if a PFIC maintains records on a monthly 
basis and allows redemptions and acquisitions of its stock only at a 
month's end, this provision would allow U.S. investors to include in 
income income actually earned by the PFIC for each month rather 



215 

than including in income under the general rule their pro rata 
share of a year's total income. 

The bill modifies the determination of a PFIC's earnings and 
profits. This modification provides that earnings and profits are 
computed using the installment method of accounting (and the 
completed contract method of accounting and the LIFO inventory 
method, if applicable) if a PFIC uses the method to compute its 
income. For example, if a PFIC uses the installment method of ac- 
counting in computing its income, U.S. investors' pro rata shares of 
income will take into account that method. This modification only 
affects earnings and profits for income inclusion purposes. Thus, it 
does not change earnings and profits for purposes of determining, 
for example, if a distribution is a dividend. The modification also 
provides, however, that, under regulations, if the earnings and 
profits arising from the installment method and considered de- 
ferred for income inclusion purposes are distributed prior to the 
year that they would otherwise be included in income {e.g., the 
year in which the installment receivable is collected), those earn- 
ings are not to be included in income in the later year. This latter 
rule is necessary to eliminate the potential for double taxation of 
those earnings. 

The bill clarifies that disposition, for purposes of determining 
whether an extension of time to pay tax on undistributed PFIC 
earnings terminates, means any transfer of stock, regardless of 
whether it would give rise to a realization or recognition event 
under general Code rules. For example, a transfer of stock by gift 
causes a termination of all prior extensions of time to pay tax for 
the earnings attributable to that stock. 

The bill provides modifications to the rules applicable to PFICs 
that are qualified electing funds that are also controlled foreign 
corporations. First, the amount of income treated as ordinary 
income on a sale or exchange of stock in a controlled foreign corpo- 
ration (under sec. 1248) does not include any amount of income pre- 
viously included under the qualified electing fund rules to the 
extent that that amount of income has not been distributed from 
the PFIC prior to the sale or exchange of stock. Further, look- 
through treatment is provided in determining the foreign tax 
credit limitation treatment of income inclusions under the quali- 
fied electing fund rules when (1) the PFIC is also a controlled for- 
eign corporation, and (2) the U.S. person with the income inclusion 
is a U.S. shareholder in the controlled foreign corporation. 

Special rules applicable to both types of funds 

Attribution of ownership 

The bill provides that under regulations any person who has an 
option to acquire stock shall be treated as owning the stock. It is 
anticipated that regulations will provide this treatment where nec- 
essary to prevent avoidance of the imposition of interest. 

Anti-avoidance rules 

The bill also provides that under regulations if a U.S. person is 
treated as owning stock in a PFIC by virtue of the attribution 
rules, any distribution to the actual holder of the stock is treated 



216 

as a distribution to the U.S. person. It is anticipated that regula- 
tions will provide this treatment where necessary to prevent avoid- 
ance of the imposition of interest. In these cases, the bill also pror 
vides that the amounts deemed distributed to the U.S. person are 
not to be included in gross income of the holder actually receiving 
those amounts for purposes of causing the U.S. person to include 
those amounts in income again. 



E. Treatment of Foreign Taxpayers 

1. Branch profits tax (sec. 112(o) of the bill, sec. 1241 of the 
Reform Act, and sees. 26, 861, 884, 906, and 2104 of the Code) 

Present Law 

Overview 

The Act imposed bi-anch-level taxes on profits of foreign corpora- 
tions operating businesses in the United States and on interest 
paid or deducted by U.S. businesses operated by foreign corpora- 
tions. The Act also reduced the U.S. business threshold that trig- 
gers the withholding tax on dividends paid by foreign corporations 
(applicable where the branch profits tax cannot be applied). 

Branch profits tax 

A tax of 30 percent is imposed on a foreign corporation's "divi- 
dend equivalent amount." The "dividend equivalent amount" is the 
earnings and profits of a U.S. branch of a foreign corporation at- 
tributable to its income effectively connected (or treated as effec- 
tively connected) with a U.S. trade or business, subject to two ad- 
justments (detailed below). The determination of effectively con- 
nected earnings and profits is made without reduction for dividend 
distributions made by a foreign corporation during a year, so that 
tax is imposed on a foreign corporation that has current earnings 
(which are not reinvested in a branch's trade or business, as de- 
tailed below). 

In arriving at the dividend equivalent amount, a branch's effec- 
tively connected earnings and profits are adjusted in two circum- 
stances. These adjustments identify changes in a branch's U.S. net 
equity (the difference between a branch's assets that are treated as 
connected with its U.S. trade or business and its liabilities that are 
so treated) that reflect profit remittances during a taxable year. 
The first adjustment to the dividend equivalent amount reduces 
the tax base to the extent the branch's earnings are reinvested in 
trade or business assets in the United States (or reduce trade or 
business liabilities). This reduction is measured by the increase in 
the U.S. net equity of the branch: the difference between (1) the 
excess of the money and adjusted basis of the branch's assets over 
its liabilities at the end of the year and (2) the excess of the money 
and adjusted basis of its assets over its liabilities at the end of the 
preceding year. The second adjustment increases the tax base to 
the extent prior reinvested earnings are considered remitted to the 
home office of the foreign corporation. This adjustment is meas- 
ured by the reduction in the U.S. net equity of the branch: the dif- 
ference between (1) the excess of the money and adjusted basis of 
the branch's assets over its liabilities at the end of the preceding 
year and (2) the excess of the money and adjusted basis of the 

(217) 



218 

branch's assets over its liabilities at the end of the year. The in- 
crease in the tax base on account of a decrease in U.S. net equity is 
intended to be limited to the amount of prior earnings that have 
not been remitted to the home office, unless a branch has current 
earnings. 

Branch-level interest tax 

Interest paid by a U.S. trade or business of a foreign corporation 
is treated as if paid by a U.S. corporation and, hence, is U.S. source 
and subject to U.S. withholding tax of 30 percent, unless the tax is 
reduced or eliminated by a specific Code or treaty provision. It is 
intended that where this interest is paid to a U.S. person or a U.S. 
trade or business of a foreign person, the interest is also to be 
treated as U.S. source but not subject to withholding since it is sub- 
ject to tax on a net income basis in the hands of the recipient. To 
the extent a U.S. branch of a foreign corporation has allocated to it 
under Treasury Regulation section 1.882-5 an interest deduction in 
excess of the interest actually paid by the branch (this generally 
occurs where the indebtedness of the U.S. branch is disproportion- 
ately small compared to the total indebtedness of the foreign corpo- 
ration), the excess is treated as if it were interest paid on a notion- 
al loan to a U.S. subsidiary (the U.S. branch, in actuality) from its 
foreign corporate parent (the home office). This excess is also sub- 
ject to the 30-percent tax, absent a specific Code exemption or 
treaty reduction. 

For purposes of determining whether the tax on the excess inter- 
est is to be reduced or eliminated by treaty, the applicable income 
tax treaty is the one between the United States and the country of 
the corporation's home office, subject, however, to the prohibition 
against treaty shopping. In the case of U.S. withholding tax on in- 
terest actually paid by a branch to a foreign recipient, the appro- 
priate treaty will be that between the United States and the coun- 
try of the recipient, subject again to the prohibition against treaty 
shopping. 

Relationship with tax treaties 

The Act provided that the branch profits tax is to yield to trea- 
ties only in two cases. The first case is where a foreign corporation 
with a U.S. branch is a "qualified resident" of a country in which 
the corporation is a resident (i.e., the corporation is not treaty- 
shopping) and the treaty prohibits the branch profits tax. The 
second case is where a foreign corporation resides in a country 
whose treaty permits the United States to impose its withholding 
tax on dividends paid by the corporation but otherwise prohibits 
the branch profits tax, whether or not the foreign corporation is 
treaty shopping. In this second case, however, the foreign corpora- 
tion paying the dividends cannot claim any treaty benefits (i.e., re- 
duced rates) with respect to the dividends it pays if it is treaty 
shopping. The Act also prohibited any foreign corporation that re- 
ceives a dividend from another foreign corporation from claiming 
any treaty benefits with respect to the dividends received if it is 
treaty shopping. 

A foreign corporation generally is treaty shopping in two cases: 
First, treaty shopping occurs if more than 50 percent (by value) of 



219 

the stock of the foreign corporation is owned (determined by look- 
ing through corporations, partnerships, estates, and trusts to ulti- 
mate individual ownership) by individuals who are not residents of 
the treaty country. U.S. citizens and resident aliens are treated as 
residents of the treaty country for this purpose. 

Second, where 50 percent or more of a foreign corporation's 
income is used to meet liabilities to persons who are not residents 
of the country in which the corporation is a resident or of the 
United States, then the corporation is treaty shopping (a "base ero- 
sion" rule). 

If a foreign corporation's stock is primarily and regularly traded 
on an established securities market in the country under whose 
treaty it claims benefits as a resident, then the corporation is con- 
sidered a qualified resident of that country. Similarly, if a foreign 
corporation's parent is organized in the same country as its subsidi- 
ary corporation, and the parent corporation's shares are primarily 
and regularly traded on an established securities market in that 
country, then the subsidiary corporation is considered a qualified 
resident of the country for purposes of the country's treaty with 
the United States. Under the Act, the publicly-traded exception 
does not automatically treat a foreign corporation that is wholly 
owned by a U.S. corporation whose stock is primarily and regularly 
traded on an established securities market in the United States as 
a qualified resident of the country in which it is a resident. A do- 
mestic corporation in this instance has to determine (in addition to 
meeting the base erosion rule) if it is more than 50-percent owned 
by either U.S. residents or residents of the country of the domestic 
corporation's subsidiary in order to be treated as a qualified resi- 
dent. 

Other rules 

The Act reduced to 25 percent prior law's business income 
threshold for imposition of the withholding tax on dividends. The 
Act also provided that the withholding tax on dividends is not ap- 
plicable where the branch profits tax generally may be imposed, 
even though no branch tax may be due in a particular taxable 
year. 

For U.S. branches of foreign corporations that have undistrib- 
uted accumulated earnings and profits as of their first taxable year 
beginning on or after January 1, 1987, the branch profits tax provi- 
sions are intended to apply only to earnings and profits generated 
in taxable years beginning after December 31, 1986, that are con- 
sidered distributed from the branch to the home office (limited by 
post-effective date earnings and profits). Prior law's withholding 
tax on dividends is intended to apply to the pre-effective date accu- 
mulated earnings and profits that are distributed after the effec- 
tive date. Thus, if a branch's income did not constitute at least 50 
percent of the corporation's income for the base period prescribed 
under prior law, there is no withholding tax imposed on dividends 
paid after 1986 that represent pre-effective date earnings. Similar- 
ly, pre-effective date deficits in earnings and profits are not intend- 
ed to be eligible to reduce post-effective date earnings in applying 
the branch profits tax. Post-effective date deficits in earnings and 
profits do not reduce pre-effective date earnings in applying prior 



220 

law's withholding tax to distributions after 1986 where the distri- 
butions are attributable to pre-effective date earnings. 

Explanation of Provision 
Branch profits tax 

The bill clarifies that the dividend equivalent amount is limited 
to the post-1986 accumulated effectively connected earnings and 
profits of the U.S. branch that have not previously been remitted 
to the branch's home office. 

Branch-level interest tax 

The bill clarifies that interest paid or deducted by a U.S. trade or 
business of a foreign corporation is U.S. source, regardless of the 
recipient. Thus, if the recipient is a foreign person not engaged in a 
U.S. trade or business the interest will be subject to U.S. withhold- 
ing tax; if the recipient is a U.S. person or a foreign person en- 
gaged in a U.S. trade or business and the interest is effectively con- 
nected therewith, the interest will not be subject to withholding 
but will be subject to U.S. tax in the hands of the recipient on a 
net income basis. 

The bill also modifies the taxation of interest paid by a U.S. 
trade or business. First, the bill excludes interest paid by interna- 
tional organizations (as defined in sec. 7701(a)(18)) from the scope of 
the provision. Second, to the extent provided in regulations, the bill 
will limit U.S. withholding to the amount of interest reasonably ex- 
pected to be deducted in arriving at the branch's effectively con- 
nected taxable income. 

Relationship with tax treaties 

The bill modifies the applicability of the branch profits tax in 
cases of treaty shopping. This modification provides that if a for- 
eign corporation is treaty shopping, the branch profits tax will be 
imposed, regardless of whether the treaty with the United States 
and the country in which the corporation is a resident allows the 
United States to impose its withholding tax on dividends. One of 
the reasons Congress enacted the branch profits tax was the diffi- 
culty of administering prior law's withholding tax. The Act's rule — 
prohibiting the imposition of the branch profits tax in cases where 
a treaty permits the U.S. withholding tax on dividends paid by a 
foreign corporation whether or not the corporation is treaty shop- 
ping — would not in some cases remedy that concern. For example, 
assume a treaty with the United States prohibits the branch profits 
tax but it permits the withholding tax on dividends if the corpora- 
tion derives 50 percent or more of its income from the United 
States. Assume further that the foreign corporation organized in 
this treaty country is treaty shopping. The result of the Act would 
be to impose the withholding tax on dividends in the years in 
which the corporation derives 50 percent or more of its income 
from the United States and to impose the branch profits tax in 
years in which the corporation's U.S. income is below that level. 
This result would be difficult to administer and would lead to tax 
avoidance techniques. 



221 

More importantly, however, Congress was concerned that foreign 
persons resident in one country would attempt to use another 
country's tax treaty with the United States to avoid the branch 
profits tax. The bill addresses this concern by not allowing treaties 
to prevail in treaty shopping cases. 

The bill clarifies that the prohibition against treaty shopping of 
recipients of interest paid or deducted by a U.S. trade or business 
of a foreign corporation applies to any person attempting to claim 
benefits under the interest articles of the treaty of the country in 
which the foreign corporation is a resident. The bill continues to 
allow, however, the recipient to claim benefits under the treaty in 
the country in which the recipient is a resident, unless the recipi- 
ent is treaty shopping as well. 

The bill modifies the definition of treaty shopping in two re- 
spects. First, the bill provides that if nonresidents of a treaty coun- 
try own 50 percent or more of the value of stock of a corporation 
the corporation is considered treaty shopping. This modification 
generally accords with the ownership limitation in recent U.S. 
income tax treaties. Second, the bill modifies the publicly traded 
exception to treaty shopping to provide that a foreign corporation 
that is wholly owned by a domestic corporation whose stock is pri- 
marily and regularly traded on an established securities market in 
the United States is to be treated as a qualified resident of its 
country of residence. This modification accords with the Act's pre- 
sumption that corporations whose stock is primarily and regularly 
traded on a local securities market is more than 50 percent owned 
by local residents and with the Act's treatment of U.S. persons as 
treaty-country residents. 

Other rules 

The bill clarifies that the withholding tax on dividends is not im- 
posed for any taxable year with respect to dividends paid out of 
earnings and profits of the corporation for that year if the branch 
profits tax may be imposed for that year (even if no branch profits 
tax may be due in that year). Thus, the withholding tax on divi- 
dends may be imposed in two cases. First, the withholding tax may 
be imposed on dividends that are attributable to pre-1987 earnings 
and profits. Second, the withholding tax may be imposed on divi- 
dends that are attributable to any earnings and profits when the 
branch profits tax is prohibited by a treaty with the United States, 
regardless of when the dividends are distributed. Thus, in this 
latter case, the withholding tax on dividends may be imposed in a 
year a foreign corporation is subject to the branch profits tax if the 
dividends are attributable to years in which the branch tax is pro- 
hibited, for example, by a treaty. 

2. Treatment of deferred payments and appreciation arising out of 
business conducted within the United States (sec. 112(p) of the 
bill, sec. 1242 of the Reform Act, and sec. 864(c) of the Code) 

Present Law 

The Act provides that any income or gain of a nonresident alien 
individual or foreign corporation for any taxable year which is at- 



222 

tributable to a sale or exchange of property, the performance of 
services, or any other transaction, in any other taxable year shall 
be treated as effectively connected with the conduct of a trade or 
business within the United States if it would have been so treated 
if such income or gain were taken into account in such other tax- 
able year (new Code sec. 864(c)(6)). Similarly, the Act provides that 
if any property ceases to be used or held for use in connection with 
the conduct of a trade or business within the United States, the de- 
termination of whether any income or gain attributable to a sale or 
exchange of such property occurring within 10 years after such ces- 
sation is effectively connected with the conduct of a trade or busi- 
ness within the United States shall be made as if such sale or ex- 
change occurred immediately before such cessation (new Code sec. 
864(cX7)). Under the Act, the amount of income or gain taken into 
account under the latter provision is not limited to the apprecia- 
tion of the property while the property was used in the United 
States, but rather is based on the amount of income or gain recog- 
nized at the time of the sale or exchange. 

A foreign corporation engaged in a trade or business during the 
taxable year is taxable on a net basis on its income v/hich is effec- 
tively connected with the conduct of a trade or business within the 
United States (Code sec. 882(a)). The same treatment applies to 
nonresident alien individuals (Code sec. 871(b)). 

Explanation of Provision 

In the case of payments for sales or exchanges of property, the 
performance of services, or any other transaction, that are deferred 
from one taxable year to a later taxable year, the determination 
whether such income or gain is taxable on a net basis (under sec. 
871(b) or 882(a)) is to be made as if the income were taken into ac- 
count in the earlier year and without regard to the requirement (of 
sec. 871(b) or 882(a)) that the taxpayer be engaged in a trade or 
business within the United States during the later taxable year. 
The bill makes a similar amendment to the Act's provision taxing 
dispositions of property formerly used or held for use in connection 
with the conduct of a trade or business within the United States 
and disposed of within 10 years after that cessation of use. For this 
purpose, the property is treated as being sold or exchanged imme- 
diately before it ceased to be used or held for use in connection 
with the conduct of a trade or business in the United States, and 
the requirement (of sec. 871(b) or 882(a)) that the taxpayer be en- 
gaged in a trade or business within the United States during the 
taxable year for which such income or gain is taken into account is 
disregarded. 

3. Withholding tax on amounts paid by partnerships to foreign 
partners (sec. 112(q) of the bill, sec. 1246 of the Reform Act, 
and sees. 872, 882, and 1446 of the Code) 

Present Law 
Partnership withholding 

Prior to the Act, partnerships that conducted a trade or business 
in the United States generally were not required to withhold U.S. 



223 

tax on distributions to foreign persons that were attributable to the 
U.S. business income of the partnership. Under the Act, however, 
partnerships must withhold in these circumstances. This withhold- 
ing requirement supplements other withholding requirements ap- 
plicable to certain generally passive U.S. source income derived by 
partnerships that have foreign partners. 

Under the Act, the following withholding rules apply to distribu- 
tions to foreign partners in U.S. or foreign partnerships that have 
any income effectively connected with the conduct of a U.S. trade 
or business. First, withholding at 30 percent (sometimes reduced or 
eliminated under treaties) is required with respect to distributions 
attributable to certain U.S. source fixed or determinable annual or 
periodic income not effectively connected with the conduct of a 
U.S. trade or business. It is intended that any distribution by the 
partnership be considered to come first out of these types of income 
received by the partnership. 

Second, any partnership distribution in excess of the amounts de- 
scribed immediately above is subject to withholding at a 20-percent 
rate. The amount withheld is creditable against the U.S. income 
tax liability of the foreign partner. Amounts withheld in excess of 
a foreign person's tax liability are treated as an overpayment of 
tax. 

Third, if a partnership's gross income effectively connected with 
a U.S. trade or business over a three-year period (or shorter period 
if the partnership is not in existence for three years) is less than 80 
percent of the total gross income of the partnership over that 
period, then withholding is required only on the proportion of cur- 
rent distributions that the partnership s gross income effectively 
connected with its U.S. trade or business bears to the partnership's 
total gross income over its previous three taxable years (or shorter 
period if the partnership is not in existence for three years). 

Fourth, the Act provides that, unless otherwise provided in regu- 
lations, withholding is not required if substantially all of the U.S. 
source income and substantially all of the income effectively con- 
nected with a partnership's U.S. trade or business is allocable to 
U.S. partners pursuant to a valid special allocation under section 
7040t>) and the regulations thereunder. This provision exempting 
amounts from withholding is not intended to apply to a partner- 
ship which has only U.S. source income and in which foreign per- 
sons hold only a minority interest such that, on a straight alloca- 
tion, "substantially all" of the partnership's income could be con- 
sidered to be allocated to U.S. persons. Instead, it is intended to 
apply only to a partnership which specially allocates its U.S. source 
income to U.S. persons and its foreign source income to foreign per- 
sons. 

Taxation of foreign persons 

Nonresident alien individuals and foreign corporations generally 
are subject to U.S. tax only on their gross income which is derived 
from U.S. sources and which is not effectively connected with the 
conduct of a trade or business in the United States and on their 
gross income which is effectively connected with the conduct of a 
trade or business in the United States (sees. 872(a) and 882(b)). 
United States tax on the former type of gross income generally is 



! 224 

collected by withholding whereas U.S. tax on the latter type of 
gross income generally is collected by the filing of a U.S. tax return 
and payment of estimated taxes. 

Explanation of Provision 

Partnership withholding 

The bill modifies the rule that requires withholding only on a 
proportion of current distributions by a partnership if the partner- 
ship's gross income effectively connected with its U.S. trade or 
business is less than 80 percent of the partnership's total gross 
income. For this purpose, gross income, the denominator of the 
fraction, does not include any U.S. source fixed or determinable 
annual or periodical income (i.e., income that is described in sec. 
1441(b)) which is not effectively connected with the conduct of the 
partnership's U.S. trade or business. 

The bill modifies the exception to 20-percent withholding for 
amounts already subject to U.S. withholding tax on a gross basis 
(except where eliminated by treaty). This exception is extended to 
certain types of U.S. source income that are exempt from U.S. tax 
under the Code, that is, to portfolio interest and bank deposit inter- 
est. Thus, amounts that are subject to U.S. withholding tax at a 30- 
percent rate (or a lower treaty rate) or that would be subject to 
withholding but for a Code or treaty exemption are not subject to 
the 20-percent withholding rule. Distributions by a partnership 
would be considered to come first out of these types of income re- 
ceived by the the partnership. 

The bill clarifies the exception to 20-percent withholding for 
partnerships with certain special allocations of partnerships' dis- 
tributive shares. This clarification provides that the exception ap- 
plies only to a partnership which specially allocates its U.S. income 
to U.S. persons and its foreign income to foreign persons. 

Taxation of foreign persons 

The bill clarifies the meaning of gross income for nonresident 
alien individuals and foreign corporations. Under the bill, sections 
872(a) and 882(b) are modified so that, for those persons, unless the 
context clearly indicates otherwise, gross income includes only 
gross income which is derived from sources within the United 
States and which is not effectively connected with the conduct of a 
trade or business within the United States, and gross income which 
is effectively connected with the conduct of a trade or business 
within the United States. For example, when the taxpayer at issue 
is a nonresident alien individual or a foreign corporation, gross 
income subject to direct U.S. income tax includes onlj'^ that gross 
income which is derived from U.S. sources and which is not effec- 
tively connected with the conduct of a U.S. trade or business and 
that gross income which is effectively connected with the conduct 
of a U.S. trade or business. By contrast, a partnership's gross 
income, for purposes of determining the proportion of distributions 
by a partnership that is subject to 20 percent withholding, is all 
income from whatever source derived (as determined under sec. 
61), except as specifically modified by the change described above. 
Thus, a partnership's gross income will include its gross income de- 



225 

rived from foreign operations in addition to that gross income de- 
rived from its U.S. operations. 

4. Income of foreign governments (sec. 112(r) of the bill, sec. 1247 
of the Reform Act, and sec. 892 and 893 of the Code) 

Present Law 

The Act provides that the income of foreign governments re- 
ceived from investments in the United States in stocks, bonds, or 
other domestic securities owned by such foreign governments is not 
included in gross income and is exempt from income taxation (Code 
sec. 892). In addition, the Act provides that the exemption does not 
apply to any income received from or by a controlled commercial 
entity. The Act's legislative history indicates that, for treaty pur- 
poses, a foreign government is to be treated as a resident of its 
country, unless it denies similar treaty benefits to the United 
States. 

In certain cases, wages, fees, or salary of an employee of a for- 
eign government received as compensation for official services to 
such government is excluded from gross income and is exempt 
from income taxation (Code sec. 893). 

Explanation of Provision 

The bill makes it clear that the Code provision benefiting certain 
income of foreign governments (sec. 892) neither excludes from 
gross income nor exempts from tax income derived from the dispo- 
sition of any interest in a controlled commercial entity. Thus, this 
Code provision does not benefit such income, whether or not such 
income is received from investments in the United States in stocks, 
bonds, or other domestic securities owned by a foreign government. 
Such income may not be taxable for independent reasons: for ex- 
ample, a sale of stock of a U.S. corporation that is not a U.S. real 
property interest by a foreign person may not be subject to tax 
under general Code rules. For this purpose, however, a commercial 
entity is to include any U.S. real property holding corporation 
(Code sec. 897(c)(2)). 

In addition, the Code's exclusion from gross income and exemp- 
tion from taxation do not apply to income received indirectly frorn 
a controlled commercial entity (as well as to income received di- 
rectly from such an entity). For example, assume that a foreign 
government owns all the shares of a U.S. holding company that 
owns all the shares of a U.S. operating company. The U.S. holding 
company deducts all the dividends it receives from the operating 
company by virtue of the 100-percent dividends received deduction. 
Under the bill, dividends from the holding company to the foreign 
government are not exempt, because they are received indirectly 
from a controlled commercial entity. 

The bill codifies the rule that a foreign government, for income 
tax treaty purposes, is treated as a corporate resident of its country 
if it grants equivalent treatment to the U.S. government. In addi- 
tion, for purposes of the Internal Revenue Code, a foreign govern- 
ment is treated as a corporate resident of its country (whether or 
not it treats the U.S. government as a U.S. resident). 



226 

The bill conforms the gross income exclusion and tax exemption 
for wages, fees, or salary of an employee of a foreign government to 
the exclusion and exemption for governments themselves. Under 
the bill, the exclusion and exemption are not available to an em- 
ployee of a foreign government whose services are primarily in con- 
nection with a commercial activity (whether within or outside the 
United States) of the foreign government, or to any employee of a 
controlled commercial entity of a foreign government. 

5. Dual residence companies (sec. 112(s) of the bill, sec. 1249 of 
the Reform Act, and Sec. 1503 of the Code) 

Present Law 

The Act provides that if a U.S. corporation is subject to a foreign 
country's tax on worldwide income, or on a residence basis as op- 
posed to a source basis, any net operating loss it incurs cannot 
reduce the taxable income of any other member of a U.S. affiliated 
group for that or any other taxable year. A net operating loss of 
such a company is referred to as a "dual consolidated loss." Regula- 
tory authority is provided to exclude a loss from the ambit of this 
rule to the extent that that loss does not offset the income of for- 
eign corporations for foreign tax purposes. 

Explanation of Provision 

The bill provides that, to the extent provided in regulations, any 
loss of any separate and clearly identifiable unit of a trade or busi- 
ness of the taxpayer is to be treated as a dual consolidated loss as 
if that unit were a wholly owned subsidiary of that corporation. 
For example, assume that a U.S. corporation maintains a branch in 
a foreign country. That foreign country allows the loss of that 
branch to offset the taxable income of a locally incorporated corpo- 
ration that is wholly owned by the U.S. corporation (or an affiliate 
of the U.S. corporation). The branch incurs, for both U.S. and for- 
eign tax purposes, a net operating loss of $100. The foreign corpora- 
tion earns income of $100. The U.S. corporation, viewed as a whole, 
has neither gain nor loss for the year: the $100 loss of the branch 
offsets $100 of income generated by the rest of the U.S. corporation. 
Under the bill, regulations may provide that the branch's $100 loss 
is treated as a dual consolidated loss. It is anticipated that regula- 
tions will so provide to the extent that the branch's loss offsets the 
income of a foreign corporation for foreign purposes. In that case, 
that loss may not be used to offset the income that the U.S. corpo- 
ration earns other than from the branch operation. Thus, the tax- 
able income of the U.S. corporation is $100. The branch's $100 loss 
is available for carryforward against future income of the branch. 






F. Foreign Currency Exchange Rate Gains and Losses (sec. 112(t) 
of the bill, sec. 1261 of the Reform Act, and sees. 986-989 of the 
Code) 

1. Foreign currency translation 

Present Law 

Translation of foreign income taxes 

Generally for purposes of computing either the direct or indirect 
foreign tax credit, the amount of foreign income taxes paid to a for- 
eign government or U.S. possession is translated, under subpart J 
of the Code as added by the Act, using the exchange rate in effect 
as of the time of payment; any refund or credit of a foreign income 
tax is translated using the exchange rate in effect as of the time of 
the original payment; and any increase in the amount of a foreign 
income tax is intended to be translated using the exchange rate in 
effect when the increase is paid. (Congress did not intend the pay- 
ment date rule to prevent the allowance of a credit based on ac- 
crued foreign taxes where those taxes are unpaid when the credit 
must be computed.) 

Translation of section 956 income inclusions 

On the actual distribution of earnings and profits from a foreign 
corporation to a U.S. taxpayer, the latter is required to translate 
such amounts (if necessary) at the current exchange rate on the 
date the distribution is included in income. In the case of deemed 
distributions under section 951(a) of subpart F, the required income 
inclusion is first calculated in the functional currency and then 
translated at the weighted average exchange rate for the foreign 
corporation's taxable year. The Secretary may adjust these transla- 
tion rates by regulation. 

Where earnings of a controlled foreign corporation are repatriat- 
ed, the Code generally aims at achieving similar tax results wheth- 
er the repatriation is in the form of a dividend or of an increase in 
investment in U.S. property (see sees. 951(a)(1)(B) and 956). Howev- 
er, the translation rules described above provide for computing 
translation rates differently depending on the form of repatriation. 
Congress did not intend to provide taxpayers their choice of tax re- 
sults based on translation method where a similar economic result 
is achieved in either case. 

Explanation of Provisions 
Translation of foreign income taxes 

The bill clarifies that the exchange rate to be used for deterniin- 
ing the dollar cost of any payment of foreign income tax (including 
a payment constituting an adjustment to a payment of foreign tax) 

(227) 



228 

is the exchange rate as of the time the taxes are paid to the foreign 
country or U.S. possession. The bill applies this rule whether the 
entity paying the tax to the foreign government or U.S. possession 
is the taxpayer or (as in the case where the taxpayer claims an in- 
direct foreign tax credit) a corporation of which the taxpayer is a 
shareholder, and whether or not the tax is paid by a qualified busi- 
ness unit. 

Translation of section 956 income inclusions 

The bill provides that subpart F inclusions under section 
951(a)(1)(B), relating to increases in investments in U.S. property, 
are to be translated at the same rates as actual distributions made 
on the last day of the taxable year, i.e., using the spot rate on that 
day. This reduces the opportunity for taxpayers to manipulate tax 
liability based on the foreseeable difference between the weighted 
average annual rate and the spot rate as of the date when earnings 
repatriation is to occur. The Secretary retains authority to further 
adjust translation rates, under regulations, where regulatory ad- 
justments can usefully promote the aim of reducing similar oppor- 
tunities for manipulation. 

2. Foreign currency transactions 

Present Law 

Section 988(c) defines the term "section 988 transaction" to in- 
clude (1) the acquisition of (or becoming the obligor under) a debt 
instrument, (2) the disposition of nonfunctional currency, and (3) 
entering into or acquiring any forward contract, option, or similar 
financial instrument (such as a currency swap), if such instrument 
is not marked to market at the close of the taxable year under sec- 
tion 1256. Congress did not intend to change generally the treat- 
ment of bank forward contracts, regulated futures contracts, or 
other contracts subject to the mark-to-market rule under section 
1256. Therefore, Congress intended to exclude such instruments 
from the definition of a section 988 transaction. 

Section 988(b) defines foreign currency gain or loss as gain or loss 
on a section 988 transaction, but only to the extent the gain or loss 
is realized by reason of a change in exchange rates between the 
booking date with respect to that transaction and the- payment 
date of the transaction. In the case of any disposition of nonfunc- 
tional currency, the relevant period for measuring rate changes is 
the time between acquisition and disposition of the currency. 

For transactions involving forward contracts or similar positions, 
the booking date is the date on which the position is entered into 
or acquired; the payment date includes the date on which a taxpay- 
er's rights are terminated with respect to the position (e.g., by en- 
tering into an offsetting position). The definition of foreign curren- 
cy gain or loss is intended to apply to gain or loss attributable to 
exchange rate movements between those dates affecting the value 
of forward contracts or similar instruments, regardless of the par- 
ticular transaction in which the gain or loss is realized. 

The Secretary has general authority to provide the regulations 
necessary or appropriate to carry out the purposes of new subpart 
J. For example, where a debt instrument, the acquisition of which 



229 

is a section 988 transaction, is converted to stock, the sale of which 
is not a section 988 transaction, the Act gives the Secretary the au- 
thority to prevent any foreign currency gain inherent in the debt 
instrument from escaping subpart J treatment. 

The Act authorizes the issuance of regulations that address the 
treatment of transactions that are part of a section 988 hedging 
transaction. To the extent provided in regulations, in the case of 
any transaction giving rise to foreign currency gain or loss that is 
part of a section 988 hedging transaction (determined without 
regard to whether any position in the hedge would be marked to 
market under section 1256), all positions in the hedging transaction 
are integrated and treated as a single transaction, or otherwise 
treated consistently (e.g., for purposes of characterizing the nature 
of income or the sourcing rules). In the case of a foreign currency 
borrowing fully hedged with a series of forward purchase contracts, 
for example. Congress intended that regulations treat the entire 
package as a dollar borrowing with dollar interest payments sub- 
ject to the rules of section 1271 et seq. and 163(e) for determining 
the appropriate interest deduction. 

Explanation of Provisions 
Exclusion from section 988 treatment for 1256 contracts 

The bill provides that if a forward contract, futures contract, 
option, or similar financial instrument would have been marked to 
market under section 1256 were it held on the last day of the tax- 
able year, then the instrument is not a "section 988 transaction" 
even if it is not actually marked to market under section 1256 at 
the close of the taxable year. This amendment clarifies that taxpay- 
ers who acquire 1256 contracts cannot elect 988 rules for character- 
izing, timing, and sourcing or allocating the income or loss on such 
contracts simply by disposing of the contracts prior to the last day 
of the taxable year. 

Measurement of foreign currency gain or loss 

The bill provides that any gain or loss from a section 988 trans- 
action is a foreign currency gain or loss if the transaction is a dis- 
position of nonfunctional currency or a forward contract, futures 
contract, option, or similar financial instrument with respect to a 
nonfunctional currency. This makes it clear that any gain or loss 
on such an instrument due to forward premium or forward dis- 
count is subject to the Act's rules for foreign currency gains and 
losses, regardless of movements in the spot rates of exchange be- 
tween the booking and payment dates. Further, any gain or loss on 
a nonfunctional currency disposition is foreign currency gain or 
loss regardless of whether the difference between acquisition and 
disposition prices is due to spot rate movements between acquisi- 
tion and disposition dates, forward discount or premium, bid-asked 
spreads, or other factors. 

Recognition of gain or loss on delivery under a futures contract, etc. 

The bill provides that making or taking delivery under a section 
988 transaction that is a forward contract, futures contract, option 
or similar financial instrument is a gain or loss recognition event 



230 

{cf. sec. 1256(c)), and the payment date in such a case is the date of 
making or taking delivery. This rule prevents taxpayers from 
opting for alternate treatment on such a transaction by selling or 
otherwise closing out the position, on the one hand, or taking or 
making delivery, on the other. Under a transitional provision, this 
rule will not change the treatment of deliveries taken by a taxpay- 
er on or before the date of the bill's introduction. 

Section 988 hedging transactions 

The bill provides that where all transactions that are part of a 
section 988 hedging transaction are integrated and treated as a 
single transaction or otherwise treated consistently under regula- 
tions, such treatment applies for purposes of all provisions in sub- 
title A of the Code. Thus the bill makes clear Congress's intent 
that Code provisions other than section 988 are to be applied to the 
components of a section 988 hedging transaction in their integrated 
or otherwise combined state (where regulations provide for such in- 
tegration or combination). 



G. Tax Treatment of Possessions (sec. 112(u)-(x) of the bill, sees. 
1274-1277 of the Reform Act, and sec. 932 of the Code) 

Present Law 
Mirroring of Virgin Islands coordination rule 

The Act contains a new provision coordinating U.S. and Virgin 
Islands income taxes (Code sec. 932). That Code section does not 
apply for purposes of determining income tax liability incurred to 
the Virgin Islands. The intent of Congress in not having that provi- 
sion apply for V.I. tax purposes was to prevent any argument that 
48 U.S.C. 1397 (the provision of the Naval Appropriations Act of 
1922 that holds the U.S. income tax laws, as amended, to be "like- 
wise in force in the Virgin Islands") or the Revised Organic Act of 
the Virgin Islands could require "mirroring" of the new coordina- 
tion provision for internal Virgin Islands purposes. 

Treatment of Virgin Islands residents 

The Act provides that in the case of an individual who is a bona 
fide resident of the Virgin Islands at the close of the taxable year 
and who, on his or her return of income tax to the Virgin Islands, 
reports income from all sources and identifies the source of each 
item shown on such return, for purposes of calculating income tax 
liability to the United States, gross income shall not include any 
amount included in gross income on the V.I. return. 

Effective date of prohibition of branch tax 

The provisions of the Act applicable to Guam, American Samoa, 
and the Northern Mariana Islands generally apply only if and so 
long as an implementing agreement under Act section 1271 is in 
effect between the United States and such possession. The Act pro- 
vides that, for branch tax purposes, certain corporations created or 
organized in Guam, American Samoa, the Northern Mariana Is- 
lands, or the Virgin Islands, the branch tax does not apply. This 
provision is to be mirrored, so that the branch tax does not apply 
to U.S. corporations with operations in any of those possessions. 

Explanation of Provision 
Mirroring of Virgin Islands coordination rule 

The bill provides that in applying Code section 932 (the provision 
coordinating U.S. and Virgin Islands income taxes) for purposes of 
determining income tax liability incurred to the Virgin Islands, the 
provisions of Code section 932 are not to be affected by any provi- 
sion of Federal law described in Code section 934(a), i.e., the Naval 
Appropriations Act or the Revised Organic Act. Thus, while there 
is not to be "mirroring" of this provision, this provision, insofar as 

(231) 



232 

it determines the taxable income of Virgin Islands residents, has 
effect for V.I. tax purposes. 

Treatment of Virgin Islands residents 

The bill adds to the bona fide resident requirement and the re- 
porting requirement a third requirement for exclusion of items re- 
ported on a V.I. return. That further requirement is that the indi- 
vidual seeking the exclusion fully pay his or her tax liability (re- 
ferred to in sec. 934(a)) to the Virgin Islands with respect to income 
from all sources. In addition, the bill provides that in the case of an 
individual whose gross income excludes amounts included on a V.I. 
return, allocable deductions and credits are not to be taken into ac- 
count. 

Effective date of prohibition of branch tax 

The bill makes it clear that the rule prohibiting the imposition of 
the branch tax on certain corporations organized in the possessions 
(and thus the prohibition of imposition of the branch tax by a pos- 
session on a U.S. corporation) applies for taxable years beginning 
after December 31, 1986. 



H. Miscellaneous Foreign Provisions 

1. Relationship with treaties (see. 112(y) of the bill, Title VII and 
Title XII of the Reform Act, and sec. 7852 of the Code) 

Present Law 

In general, when a statute and a treaty provision conflict, the 
one adopted later controls. When Congress enacted the Internal 
Revenue Code of 1954, it included in that Code (sec. 7852(d)) a state- 
ment that no provision of the Internal Revenue title, i.e., the Inter- 
nal Revenue Code, was to apply in any case where its application 
would be contrary to any treaty obligation of the United States in 
effect on the date of enactment of the 1954 Code (August 16, 1954). 
The intent of that provision was to provide a transitional rule to 
ensure that the substitution of the 1954 Code for the preexisting 
1939 Code did not operate to override then-existing treaty provi- 
sions. A House bill provision amending Code section 7852(d) to re- 
flect that intent — that post-1954 statutory changes not yield to pre- 
1954 treaties — was inadvertently dropped in the 1986 Tax Reform 
Act. 

In a number of respects, the interaction between the Act and 
U.S. treaties is unclear. 

Explanation of Provision 

The bill modifies the 1954 transition rule (embodied in Code sec. 
7852(d)) governing the relationship between treaties and the Code 
to clarify that it does not prevent application of the general rule 
providing that the later in time of a statute or a treaty controls 
(Code sec. 7852(d)). The bill provides that no provision of the Inter- 
nal Revenue title that was in effect on August 16, 1954, shall apply 
in any case where its application would be contrary to any treaty 
obligation of the United States in effect on the date of enactment 
of the 1954 Code (August 16, 1954). This provision makes it clear 
that treaty provisions that were in effect in 1954 and that conflict 
with the 1954 Code as originally enacted are to prevail over then- 
existing statutes but not over later-enacted statutes. 

The bill clarifies the interaction between the 1986 Act and provi- 
sions of U.S. treaties. The bill provides that the following provi- 
sions of the 1986 Act will not apply to the extent that their applica- 
tion would be contrary to any income tax treaty obligation of the 
United States in effect on the date of enactment of the 1986 Act 
(October 22, 1986): subsections (b) and (c) of section 1212 of the Act 
(imposing a 4-percent gross withholding tax on certain transporta- 
tion income earned by foreign persons and amending the rules that 
allow a reciprocal exemption for certain transportation income 
earned by foreign persons); section 1247 of the Act (relating to the 
exemption that the United States provides to foreign governments 

(233) 



234 

in some cases); and section 1242 of the Act insofar as it relates to 
new Code section 864(c)(7) (treating gain from sale of assets used in 
a U.S. trade or business as effectively connected income after cessa- 
tion of the trade or business in certain cases). In addition, in the 
event of conflict with an income tax treaty, the source rules of sec- 
tion 1212(a) of the Act (governing the source of certain transporta- 
tion income), of section 1214 of the Act (governing the source of 
payments from 80/20 companies) will not apply except for purposes 
of the foreign tax credit limitation. Further, the provisions of sec- 
tion 1241 of the Act that relate to new Code section 884(D(1)(A) (to 
the extent that that provision treats interest paid in excess of in- 
terest deducted as U.S. source) and to Code section 861(a)(2)(B) (re- 
ducing the fraction of U.S. income that exposes a foreign corpora- 
tion to U.S. withholding tax on dividend payments it makes) will 
not apply in the event of a treaty conflict. In addition, in the event 
of conflict with an income tax treaty, the source rules of section 
1211 of the Act (determining the source of income from certain 
sales of personal property) will not apply to individuals treated as 
residents of a treaty country under a U.S treaty. 

The bill's amendments to Act section 1211, described above, pro- 
vide a coordination rule for cases where sales of stock yield foreign 
source income under an income tax treaty and U.S. source income 
under new Code section 865. 

The bill provides that the following provisions of the 1986 Act 
will apply notwithstanding any treaty provision in effect on the 
date of enactment of the 1986 Act (October 22, 1986): section 1201 
of the Act, amending the foreign tax credit limitation, and section 
701 of the Act (as it relates to the limitation on the use of foreign 
tax credits against minimum tax liability). 

Except for cases that have been identified in the bill or in the 
Act, no cases are known where a harmonious reading of the Act 
and U.S. treaties is not possible. It is understood that Congress in- 
tended harmonious construction of the Act and U.S. income tax 
treaties to the extent possible. Thus, in some cases, despite the ex- 
istence of technical arguments alleging the existence of a conflict, 
it is understood that no conflict exists. For example, it is under- 
stood that no nondiscrimination provision of any U.S. treaty bars 
the application of reasonable collection mechanisms designed to 
ensure the collection of a tax, the imposition of which is permitted 
by the treaty. Thus, it is understood that the Act's partnership 
withholding provision (new Code sec. 1446), which is refundable in 
appropriate cases, constitutes such a reasonable collection mecha- 
nism, and,, thus, is fully consistent with existing U.S. treaty obliga- 
tions. 

Similarly, it is understood that the Act's imposition of tax on in- 
stallment gains received after a foreign person ceases a U.S. trade 
or business (Act section 1242) is fully consistent with existing U.S. 
treaty obligations. Some treaties prevent imposition of U.S. tax on 
business profits of a foreign person unless those profits are attrib- 
utable to a permanent establishment through which the foreign 
person carries on business in the United States. It is understood 
that these treaties do not prevent imposition of U.S. tax on income 
that was, when realized, attributable to a permanent establish- 
ment, even though that income is recognized after the permanent 



235 

establishment no longer exists. Under a similar analysis, it is un- 
derstood that the Act creates no conflict with treaties in taxing 
amounts earned for personal services in the United States which 
are paid after the person earning the income no longer maintains a 
U.S. presence. 

Other Act provisions that are understood to be fully consistent 
with U.S. treaty obligations include the Act's dual residence com- 
pany provisions (Act sec. 1249) and the Act's branch level interest 
tax provisions (Act sec. 1241). In the latter case, the obligation for 
U.S. tax on a foreign corporation's "excess interest" arises from the 
foreign corporation's deduction of interest on amounts payable to 
third-party lenders. The mere collection of this tax at one time (i.e., 
the end of the corporation's taxable year) from the foreign corpo- 
rate payor of interest, rather than requiring the payor to withhold 
U.S. tax on interest payments made throughout its taxable year, 
does not make the tax discriminatory. 

Similarly, requiring recognition of gain by a domestic corpora- 
tion that is liquidating into a foreign parent corporation or engag- 
ing in a tax-free reorganization where the domestic corporation's 
assets are being removed from U.S. taxing jurisdiction does not vio- 
late any nondiscrimination clause. In some cases, provisions based 
on capital ownership prohibit imposition of more burdensome taxes 
on foreign-owned U.S. enterprises than on similar U.S.-owned U.S. 
enterprises. For this purpose, however, a U.S. enterprise transfer- 
ring assets to a shareholder who will bear U.S. corporate level tax 
on the income generated by those assets is not similar to a U.S. en- 
terprise transferring assets to a shareholder who will not bear U.S. 
corporate level tax on the income generated by those assets. Thus, 
the Act's provision recognizing gain in these cases (sec. 631(d)) (and 
the bill's provision making modifications thereto) is fully consistent 
with U.S. treaty obligations. 

If, in any of the cases described above where conflicts are under- 
stood not to exist, any treaty is somehow read to bar operation of 
the Act, the Act is to be effective notwithstanding the treaty. 

Notwithstanding Congress' intent that the Act and income tax 
treaties be construed harmoniously to the extent possible, conflicts 
other than those addressed in this bill or in the Act ultimately may 
be found to exist. Therefore, the bill provides that except as other- 
wise provided by the bill or the Act, the provisions of the 1986 Act 
will apply notwithstanding any treaty provision in effect on the 
date of enactment of the 1986 Act (October 22, 1986). If any such 
now-unknown conflict is ultimately found, it is expected that full 
legislative consideration of that conflict will take place to deter- 
mine whether application of the general later-in-time rule is appro- 
priate. 

In addition, this technical corrections bill is understood not to 
conflict with any treaty. Again, should a conflict ultimately .appear, 
the bill's provisions are to take effect. 



236 

2. Foreign personal holding companies (sec. 112(z)(l) of the bill, 
sec. 1810(h) of the Reform Act, and sees. 551 and 552 of the 
Code) 

Present Law 

Estates and trusts owning shares of foreign personal holding compa- 
nies 

United States shareholders in a foreign personal holding compa- 
ny (FPHC) are subject to current U.S. tax on their pro rata share 
of the company's undistributed FPHC income. The FPHC rules 
were enacted in 1937 to prevent U.S. taxpayers from accumulating 
income tax-free in foreign "incorporated pocketbooks." 

In 1937 there was no statutory definition distinguishing estates 
and trusts that were U.S. taxpayers (for revenue act purposes in 
general) from those that were not. For purposes of the FPHC rules, 
an estate or trust was considered a "U.S. shareholder" in an FPHC 
unless gross income of the estate or trust for federal income tax 
purposes included only income from U.S. sources. Subsequently the 
Code was amended to include generally applicable definitions of 
the terms "foreign estate" and "foreign trust." (Under current law, 
these terms mean an estate or trust, as the case may be, the 
income of which, from sources outside the United States which is 
not effectively connected with a U.S. trade or business, is not in- 
cludible in gross income under the Code's income tax provisions 
(sec. 7701(a)(31)).) 

The foreign personal holding company rules contain a tracing 
rule, added by the Tax Reform Act of 1984, to make it clear that 
U.S. taxpayers cannot avoid the FPHC rules by interposing foreign 
entities between themselves and a FPHC. The 1984 Act grants reg- 
ulatory authority to the Secretary of the Treasury to provide for 
such adjustments in the FPHC rules as may be necessary to carry 
out the purposes of this tracing rule. The 1986 Act included a tech- 
nical amendment to the tracing rule to clarify that the tracing rule 
applies to all foreign trusts and estates (as defined for Code pur- 
poses generally) interposed between U.S. taxpayers and FPHCs. 

Same country dividend and interest exception 

The 1984 Act provided that dividends and interest received by a 
foreign corporation from a person (1) related to the recipient, (2) or- 
ganized in the same country as the recipient corporation, and (3) 
having a substantial part of its assets used in its trade or business 
located in that same country, generally do not count in either the 
numerator or the denominator of the fraction that is used in deter- 
mining whether the foreign corporation is an FPHC. The 1986 Act 
provided a definition of related person for this purpose. 

Explanation of Provisions 

Estates and trusts owning shares of foreign personal holding compa- 
nies 

Under the bill, estates and trusts that are shareholders in an 
FPHC are U.S. shareholders for purposes of the FPHC rules unless 
they are foreign estates or trusts under the general Code defini- 



237 

tions of those terms. The bill clarifies that the 1986 Act's amend- 
ment to the FPHC tracing rules treats estates and trusts as inter- 
vening foreign entities if and only if they are foreign estates and 
foreign trusts under the general Code definitions. 

The bill provides that in making adjustments to the tracing rules 
by regulation, the Secretary may impose rules similar to the rules 
of Code section 1297(b)(5) (as amended by the bill) applicable to pas- 
sive foreign investment companies (PFICs). These rules would pro- 
vide for similar treatment, under regulations, of distributions from 
FPHCs, on the one hand, and entities through which FPHC owner- 
ship is attributed, on the other. For example, where stock owner- 
ship in a FPHC is attributed to a U.S. person through an interven- 
ing entity, it is anticipated that regulations would treat distribu- 
tions received by the intervening entity as being received by the 
U.S. person. (As discussed above, the bill makes a technical change 
to section 1297(b)(5) to clarify that under regulations if a U.S. 
person is treated as owning stock in a PFIC by virtue of the attri- 
bution rules, any distribution to the actual holder of the stock is 
treated as a distribution to the U.S. person.) These regulations will 
prevent reduction of FPHC income by virtue of distributions that 
result in no U.S. tax. 

Same country dividend and interest exception 

The bill makes amendments to the 1984 and 1986 Act provisions 
relating to the same country dividend and interest exception to 
FPHC income treatment. One such amendment defines a new 
term, ''related person dividend or interest," as a same country divi- 
dend or same country interest of the type excluded from FPHC 
income under the 1984 Act. The bill restores related person divi- 
dend and related person interest to the denominator of the fraction 
used in determining whether a foreign corporation is an FPHC. 
The bill also restores FPHC income treatment of a related person 
dividend or interest to the extent the dividend or interest is attrib- 
utable to income of the related person which would be FPHC 
income. 

Thus, for example, where the entire amount of a foreign corpora- 
tion's income is related person dividends and related person inter- 
est, and in any taxable year some of that income, but less than 50 
percent, is attributable to income of the related person which 
would be FPHC income, the bill prevents the foreign corporation 
from being treated as an FPHC. 

Attribution of dividends and interest to income of the related 
person is to be determined under rules similar to the foreign tax 
credit look-through provisions for dividends and interest paid to a 
U.S. shareholder by a controlled foreign corporation. Under such 
rules a dividend paid out of the earnings and profits of a corpora- 
tion is to be treated by the recipient as FPHC income in proportion 
to the FPHC earnings and profits out of which the dividend was 
paid, divided by the total earnings and profits out of which the div- 
idend was paid (cf. sec. 904(d)(3)(D)). Similarly, interest received or 
accrued from a corporation is to be treated as FPHC income to the 
extent properly allocable (under regulations prescribed by the Sec- 
retary) to FPHC income of the corporation {cf. sec. 904(d)(3)(C)). 



238 

All of the bill's provisions described above regarding foreign per- 
sonal holding companies apply to taxable years of foreign corpora- 
tions beginning after December 31, 1986. 

3. Withholding on pensions, annuities and certain other deferred 

income (sec. 112(z)(2) of the bill, sec. 1234(b) of the Reform 
Act, and sec. 3405 of the Code) 

Present Law 

The Act provides that pension benefits (and similar payments) 
are subject to withholding under section 3405 if delivered outside 
the United States. The election generally available to U.S. persons 
to forego withholding under section 3405 is not available in such 
cases. Congress enacted this provision with a view to taxing per- 
sons who reside abroad yet are likely to owe U.S. income tax on 
pension benefits (and similar payments) that they receive. 

Explanation of Provision 

The bill clarifies that the Act's automatic withholding rule does 
not apply if the recipient certifies to the payor that he or she is not 
a U.S. citizen or a resident alien of the United States, and not a 
tax avoidance expatriate. Thus under the bill the automatic with- 
holding rule generally applies to foreign-delivered pension benefits 
and similar payments to individuals subject to U.S. income tax- 
ation on their worldwide income. 

In addition, the bill restricts automatic withholding under the 
Act to those benefits and payments that are delivered outside both 
the United States and its possessions. Thus, recipients of benefits 
and payments delivered in any U.S. possession would continue to 
be eligible to elect to forego withholding on the same terms avail- 
able to taxpayers whose payments or benefits are delivered in the 
United States. These amendments would apply to distributions 
made after the date of the bill's enactment. 

4. Information exchange (sec. 112(z)(3) of the bill, sec. 1876(e) of 

the Reform Act, and sec. 6103 of the Code) 

Present Law 

Tax returns and return information generally may not be dis- 
closed by government employees except as specifically provided in 
the Code. Violation of the nondisclosure rules may result in sanc- 
tions, including criminal felony conviction in the case of a willful 
violation. One Code exception to the general nondisclosure rule 
permits disclosure of a return or return information to a competent 
authority of a foreign government which has an income tax con- 
vention, gift and estate tax convention, or other convention relat- 
ing to the exchange of tax information with the United States, but 
only to the extent provided in, and subject to the terms and condi- 
tions of, the convention. 

In 1983, the Caribbean Basin Economic Recovery Act authorized 
the Secretary of the Treasury to negotiate and conclude bilateral 
and multilateral agreements for the exchange of information with 
designated "beneficiary countries" under the Caribbean Basin Initi- 



239 

ative (CBI). Congress expected that these agreements would gener- 
ally become effective on signature, without need of prior approval 
by the Senate. These agreements with CBI beneficiary countries 
are treated as income tax conventions for purposes of the Code pro- 
vision described above authorizing disclosures of tax returns and 
return information pursuant to conventions. 

The 1986 Act provided that a country may qualify as a host coun- 
try for foreign sales corporations (FSCs) by entering into an ex- 
change of information agreement of the type provided for in the 
Caribbean Basin Economic Recovery Act, whether or not that coun- 
try is eligible to be a CBI beneficiary. 

Explanation of Provision 

The bill clarifies that tax returns and return information may be 
disclosed to a competent authority of a foreign government where 
the disclosure is made pursuant to a bilateral agreement relating 
to the exchange of tax information with the United States. Thus, 
where a country other than a CBI "beneficiary country" enters 
into a bilateral information exchange agreement of the type that 
qualifies it as a FSC host country under the Act, for example, the 
bill provides express protection to individuals who make disclosures 
in accordance with the terms of the agreement from Code sanctions 
for unauthorized disclosures. By contrast, however, the bill does 
not contemplate the release of information under multilateral 
agreements involving non-CBI countries. 

5. Maintaining the source of U.S. source income (sec. 112(z)(4) of 
the bill, sec. 1810(a) of the Reform Act, and sec. 904(g) of the 
Code) 

Present Law 

Prior to the 1984 Act, a U.S. taxpayer could convert U.S. source 
income to foreign source income by routing the income through a 
foreign corporation: interest and dividend payments from (and 
income inclusions with respect to) an intermediate foreign corpora- 
tion generally were foreign source income to the U.S. taxpayer. As 
foreign source income, the income could be free of U.S. tax under 
the foreign tax credit. 

The 1984 Act added to the foreign tax credit new "resourcing" 
rules that prevent U.S. taxpayers from converting U.S. source 
income into foreign source income through the use of an intermedi- 
ate foreign payee. These rules apply to 50-percent U.S.-owned for- 
eign corporations only. They treat certain payments from, and 
income inclusions {e.g., under the subpart F anti-tax haven provi- 
sions) arising on account of, 50-percent U.S.-owned foreign corpora- 
tions, as U.S. source. 

The 1986 Act made it clear that the source maintenance rules 
apply notwithstanding any contrary U.S. treaty obligation. 

Explanation of Provision 

The bill provides new treatment for any amount derived from a 
50-percent U.S.-owned foreign corporation that the statute would 
treat as U.S. source income (because it is attributable to an item of 



240 

U.S. source income earned by that foreign corporation) but that the 
taxpayer, pursuant to any U.S. income tax treaty, treats as foreign 
source income. To the extent attributable to an item of U.S. source 
income earned by that foreign corporation, the taxpayer's inclusion 
is treated as foreign source income that is subject to a separate for- 
eign tax credit limitation. It is anticipated, however, that for ad- 
ministrative convenience the Secretary may allow grouping of simi- 
lar items that are similarly taxed by a foreign country. 



XIII. Tax-Exempt Bond Provisions (Sec. 113 of the bill, sees. 1301, 
1302, and 1311-1318 of the Reform Act, and sees. 25, 103, and 
141-150 of the Code) 

1. Qualified small-issue bonds 

Present Law 

Allowance of post-sunset date re fundings 

Qualified small-issue bonds may be issued to finance manufactur- 
ing facilities through December 31, 1989. Authority to issue quali- 
fied small-issue bonds for nonmanufacturing facilities expired after 
December 31, 1986. 

The Reform Act allows qualified small-issue bonds issued after 
August 15, 1986, to be refunded after the applicable sunset date of 
authority to issue the type of bond involved, if — 

(a) the refunding bond has a maturity date not later than that of 
the refunded bond; 

(b) the amount of the refunding bond does not exceed the amount 
of the refunded bond; 

(c) the interest rate on the refunding bond is lower than the in- 
terest rate on the refunded bond; and 

(d) the net proceeds of the refunding bond are used to redeem the 
refunded bond not later than 90 days after the date of issuance of 
the refunding bond. 

No comparable provision was contained in the 1954 Code which 
governs such refundings of bonds originally issued before August 
16, 1986. (See, Reform Act sec. 1313(a).) 

$40-million-per-beneficiary limit 

Interest on small-issue bonds is not tax-exempt if the aggregate 
face amount of exempt-facility and qualified small-issue bonds (in- 
cluding equivalent prior-law IDBs) allocated to any beneficiary of 
the small-issue bonds exceeds $40 million. An exception to this rule 
is provided for certain current refundings of qualified small-issue 
bonds, under the same conditions as apply to post-sunset date re- 
fundings of such bonds (as described above). ^ 

Explanation of Provisions 
Allowance of post-sunset date refundings 

The bill clarifies that post-sunset date current refundings (includ- 
ing a series of such refundings) of qualified small-issue bonds (in- 
cluding small-issue IDBs), which bonds are originally issued before 
the applicable sunset date for the type of small-issue bond involved. 



1 In the case of refundings of bonds originally issued before August 16, 1986, the 90-day limit 
on completing a refunding is reduced to 30 days. See, Title XVIII of the Reform Act. 

(241) 



73-917 0-87-9 



242 

qualify for tax-exemption, without regard to whether the refunded 
(original) bonds were issued before August 16, 1986, and without 
regard to the requirement included in the Reform Act that the in- 
terest rate on the refunding bonds be lower than the rate on re- 
funded bonds. Such refundings of bonds originally issued after 
August 15, 1986, are permitted under sec. 144(a)(12) of the 1986 
Code, as modified by the bill. Refundings of bonds originally issued 
before August 16, 1986, are permitted under a parallel rule which 
is added by the bill to the 1954 Code. Under this latter rule, bonds 
may qualify to be refunded if they could have been originally 
issued on August 15, 1986 (e.g., the "substantially all" (90 percent) 
requirement of the 1954 Code applies rather than the new 95 per- 
cent use requirement). 

Post-sunset date refundings of qualified small-issue bonds are 
permitted under the bill provided that — 

(a) the average maturity of the issue of which the refunding bond 
is a part does not exceed the average maturity of the bonds being 
refunded by such issue, ^ 

(b) the amount of the refunding bond does not exceed the out- 
standing amount of the refunded bond, and 

(c) the net proceeds of the refunding bond are used to redeem the 
refunded bond not later than 90 days after the date of issuance of 
the refunding bond. 

As indicated above, the bill replaces the limitation on the matu- 
rity of each refunding bond, contained in the Reform Act, with a 
limitation on the average maturity of the refunding issue (as com- 
pared to the average maturity of the refunded bonds). However, the 
bill provides that any refunding bond issued before July 1, 1987, 
which complied with the requirement as contained in the Reform 
Act, is treated as satisfying the new requirement. 

The bill also extends the 1954 Code sunset date for small-issue 
IDBs for manufacturing facilities, from December 31, 1988, to De- 
cember 31, 1989. This change permits bonds for manufacturing fa- 
cilities which were issued before August 16, 1986 to be refunded 
through December 31, 1989, without regard to the special limita- 
tions (described above) that apply to post-sunset date refundings. 

$40-million-per-heneficiary limit 

In conjunction with the amendments described above, the bill 
makes conforming changes to the refunding exception from the 
$40-million-per-beneficiary limit on qualified small-issue bonds. 
Thus, for purposes of this exception also, the weighted average ma- 
turity of the refunding bonds is compared to that of the refunded 
bonds, and the requirement that the refunding bonds have a lower 
interest rate than the rate on the refunded bonds is deleted. The 
bill further clarifies that a series of refundings may qualify under 
this exception. As under the rules for post-sunset date refundings, 
refunding bonds issued before July 1, 1987, which complied with 
the maturity requirement as contained in the Act, are treated as 
meeting the new requirement. 



^ Average maturities, for this purpose, are determined in the same manner as for purposes of 
the limitation on private activity bond maturity to 120 percent of the economic life of the prop- 
erty being financed. 



243 

2. Student loan bonds 

Present Law 

Tax-exemption is authorized for interest on qualified student 
loan bonds, including bonds issued in connection with the Federal 
GSL and PLUS programs and certain State supplemental student 
loan programs. Bonds issued in connection with the Federal GSL 
and PLUS programs must be used to finance loans that are both (1) 
guaranteed by the Department of Education and (2) eligible for stu- 
dent assistance (SAP) payments (unless such payments are preclud- 
ed solely by virtue of the tax-exempt status of the bonds). Addition- 
ally, the interest charged to student borrowers must be restricted 
as provided in the Higher Education Act of 1965. Bonds that meet 
some, but not all, of these requirements (e.g., bonds the proceeds of 
which are used to make student loans that receive Federal guaran- 
tees, but for which SAP payments are not available) may in certain 
cases not meet the definition of State supplemental student loan 
bonds and therefore may not qualify for tax exemption. 

Explanation of Provisions 

The bill clarifies that student loan bonds that fail to satisfy some 
but not all of the requirements of Title IV of the Higher Education 
Act of 1985 may be issued under the exception for State supple- 
mental student loan bonds, provided that the bonds otherwise satis- 
fy all requirements applicable to tax-exempt supplemental student 
loan bonds. 

The bill clarifies that an issue may not qualify as an issue of 
qualified student loan bonds if the issue satisfies the trade or busi- 
ness use and security interest tests contained in the Reform Act 
(Code sees. 141(b)(1) and (2)). For purposes of this provision, "use" 
by a section 501(c)(3) educational institution solely by reason of its 
administration of a student loan program does not affect the tax- 
exempt status of an issue, provided such use does not constitute an 
unrelated trade or business of the institution. 

3. Qualified 501(c)(3) bonds 

Present Law 

Present law permits tax-exemption for interest on bonds to bene- 
fit section 501(c)(3) organizations (qualified 501(c)(3) bonds). The 
Reform Act provides that no more than $150 million of such bonds 
(other than hospital bonds) may be outstanding with respect to any 
section 501(c)(3) organization at any time. Tax exemption of bonds 
issued before August 16, 1986, is not affected by the provision; how- 
ever, such bonds count in applying the provision to bonds issued 
after August 15, 1986. 

In the case of pre-August 16, 1986 bonds, only the nonhospital 
portion of a mixed-use bond counts toward the $150-million limita- 
tion. Whether such allocations are permitted for such mixed-use 
bonds issued after August 15, 1986, is not specified in the Reform 
Act. 



244 

Explanation of Provisions 

The bill clarifies that the proportional allocation rule included in 
the $150-million-per-beneficiary limit for qualified 501(c)(3) bonds, 
for mixed hospital/nonhospital use issues, applies to bonds issued 
after August 15, 1986, as well as to bonds issued before August 16, 
1986. 

The bill also adds a statutory reference clarifying that related 
party rules, similar to those applied for purposes of the $40-million- 
per-beneficiary limitation on qualified small-issue bonds, are to 
apply under the $150-million limitation. 

4. Mortgage revenue bonds and mortgage credit certificates 

Present Law 

Under present law, authority to issue qualified mortgage bonds 
(including refundings of such bonds) terminates after December 31, 
1988. Before enactment of the Reform Act, this termination date 
was December 31, 1987. These bonds may not be refunded after ex- 
piration of authority to issue them. 

Current refundings (including a series of refundings) of qualified 
mortgage bonds originally issued before August 16, 1986, remain 
subject to the 1954 Code. {See, Reform Act sec. 1313(a).) Thus, bonds 
originally issued before August 16, 1986, may not be refunded after 
December 31, 1987. 

The Reform Act generally amends the provisions governing issu- 
ance of mortgage credit certificates (MCCs) to parallel the qualified 
mortgage bond provisions. However, the Reform Act incorrectly re- 
tained the 1987 termination date for the MCC program, rather 
than extending it to parallel the 1988 termination of authority to 
issue qualified mortgage bonds. 

Explanation of Provisions 

The bill extends the 1954 Code sunset date for qualified mortgage 
bonds from December 31, 1987, to December 31, 1988, to parallel 
the 1988 sunset contained in the 1986 Code. This permits qualified 
mortgage bonds issued before August 16, 1986, to be refunded 
through December 31, 1988. As was stated in the legislative history 
accompanjdng the Act for refundings occurring before January 1, 
1988, refundings permitted under this expansion of the transitional 
exception may not involve an extension of the period for providing 
financing to homebuyers. 

Authority to elect to issue mortgage credit certificates is ex- 
tended through December 31, 1988, to parallel the qualified mort- 
gage bond expiration date. 

5. Private activity bond volume limitation 

Present Laic 

Subject to certain exceptions. State volume limitations are im- 
posed on the issuance of (i) private activity bonds and (ii) the pri- 
vate use portion (in excess of $15 million) of governmental issues. 
Bond volume authority generally may be allocated only to facilities 
located within the State making the allocation. Under a limited ex- 



245 

ception, volume authority may be allocated to private activity 
bonds for out-of-State water-furnishing, sewage and solid waste dis- 
posal, and qualified hazardous waste disposal facilities, if the issuer 
establishes that the State's share of the use (or output) of the facili- 
ty will equal or exceed its share of the private activity bonds issued 
to financed for the facility. 

State volume authority may be carried forward for up to three 
years for certain specified purposes. 

Explanation of Provision 

The bill expands the circumstances in which State volume au- 
thority may be allocated to certain out-of-State facilities to permit 
such allocations for out-of-State facilities financed with governmen- 
tal bonds, the private use portion of which exceeds $15 million, if 
the governmental facilities (a) are equivalent to any of the catego- 
ries for which out-of-State allocations are permitted in the case of 
private activity bonds (i.e., water-furnishing facilities, sewage and 
solid waste facilities, and qualified hazardous waste disposal facili- 
ties), or (b) are governmental output facilities financed with tax- 
exempt bonds. Because of the limitation to $15 million per facility 
for private use financing for output facilities (other than water-fur- 
nishing facilities), this provision will only apply to refundings of 
such output facility bonds originally issued before September 1, 
1986. 

Allocations with respect to governmental bonds are permitted 
only if the State's share of the use (or output) of the private use 
portion of the bond-financed facility equals or exceeds the State's 
share of volume authority allocated to the facility. 

6. Public approval requirement for private activity bonds 

Present Law 

In order for interest on a private activity bond to be tax-exempt, 
a public hearing must be held and issuance of the bonds approved 
by an elected public official or legislative body. (Alternatively, issu- 
ance of the bonds may be approved by a voter referendum.) Subject 
to certain exceptions, this requirement must be satisfied by the 
governmental unit issuing the bonds (or on behalf of which the 
bonds are issued) and all other jurisdictions in which the bond-fi- 
nanced property (or part of it) is located. 

Explanation of Provision 

The bill clarifies that, in the case of qualified scholarship funding 
bonds, the public approval requirement for private activity bonds is 
to be satisfied by a governmental unit which requested organiza- 
tion of the qualified scholarship funding corporation, or requested 
it to exercise power. (See, sec. 150(d)(2)(B).) 

7. Limitation on bond-tinancing of issuance costs 

Present Law 

At least 95 percent of the proceeds of each issue of private activi- 
ty bonds must be used to finance the exempt purpose of the issue. 



246 

Amounts used to finance any costs of issuance are not treated as \ 
spent for the exempt purpose of the borrowing. Thus, these costs 
may be financed only from the so-called 5-percent "bad money" 
portion of an issue. Additionally, the amount of private activity 
bond financing that may be used to finance costs of issuance (other 
than such costs attributable to financing of credit enhancement 
fees eligible for special treatment under the arbitrage restrictions) 
is limited to two percent of the aggregate face amount of the issue. 
(For mortgage revenue bond issues not exceeding $20 million, this 
2-percent limit is increased to 3.5 percent.) 

Explanation of Provision 

The bill clarifies that the 2-percent (3.5-percent) limitation on 
bond-financing of certain private activity bond issuance costs is ap- 
plied to the proceeds, rather than the aggregate face amount, of an 
issue. Thus, no more than 2 percent of the proceeds of a private 
activity bond issue (3.5 percent, for mortgage revenue bond issues 
having proceeds of $20 million or less) may be used to finance most 
issuance-related costs. 

This provision is effective for bonds issued after June 30, 1987. 

8. Arbitrage rebate requirement 

Present Law 
General requirement 

Issuers of all tax-exempt bonds are required to rebate certain ar- 
bitrage profits earned on nonpurpose investments acquired with 
gross proceeds of the bonds. The amount required to be rebated is 
determined, and paid, on an issue-by-issue basis. Ninety percent of 
the rebate required with respect to any issue must be paid at least 
once each five years, with the balance being due no later than 60 
days after retirement of the issue. 

Exception for certain TRAN financings 

ArbitrEige profits are not required to be rebated with respect to 
an issue if all gross proceeds are expended for the governmental 
purpose of the issue within 6 months of the issue date. The Reform 
Act provides a special "safe harbor" for applying this exception to 
tax and revenue anticipation notes (TRANs). Under this safe 
harbor, if during the six-month period after the issue date, the cu- 
mulative cash-flow deficit of the governmental unit using the 
TRA_N proceeds exceeds 90 percent of the aggregate face amount of 
the issue, all net proceeds of the TRAN issue (and any earnings 
thereon) are deemed to have been spent for the purpose of the 
issue. 

Exception for small governmental units 

The Reform Act provides a further exception to the rebate re- 
quirement for bonds issued by a governmental unit having general 
taxing powers, if (a) 95 percent or more of the net proceeds of the 
issue are to be used for local governmental activities of the issuing 
governmental unit (or a governmental unit entirely within the ju- 
risdiction of the issuing governmental unit), and (b) the governmen- 



247 

tal unit reasonably expects to issue no more than $5 million of tax- 
exempt bonds during the calendar year in which the issuance 
occurs. In determining whether an issuer reasonably expects to 
exceed the $5-million limitation, bonds issued by the issuing gov- 
ernmental unit and all entities that are subordinate to it under ap- 
plicable State or local law are counted. Private activity bonds are 
not counted toward the limit and do not qualify for this exception. 
Bonds to be redeemed (other than in an advance refunding) with 
the proceeds of a later issue are not taken into account for pur- 
poses of the $5-million limit. This has the effect of preventing 
"double counting" of the refunded and refunding bonds, if the re- 
funded and refunding bonds are issued in the same calendar year. 

Exception for certain qualified student loan bonds 

The Reform Act provides a limited transitional exception to the 
rebate requirement for qualified student loan bonds issued before 
January 1, 1989, in connection with the Federal GSL and PLUS 
programs. Under this exception, the rebate requirement does not 
apply to amounts earned from investing bond proceeds during an 
initial 18-month temporary period if — 

(a) the earnings are used to pay costs of issuance financed with 
the bonds; or 

(h) the earnings are used to pay administrative costs of the stu- 
dent loan program attributable to the issue and the costs of carry- 
ing the issue, but only to the extent that the proceeds of the issue 
are used to make or finance qualified student loans before the end 
of the 18-month temporary period. 

This exception applies only to the extent issuers are not other- 
wise reimbursed for these costs. 

Explanation of Provisions 
Due date of final rebate payments 

The bill provides a special rule for determining the due date of 
the final installment of rebate payments in the case of certain 
short-term governmental financings. Under this rule, a series of 
issues that are redeemed during a 6-month period (or such longer 
period as the Treasury Department may prescribe) are to be treat- 
ed, at the election of the issuer, as one issue, provided that no bond 
which is part of any issue in the series (a) has a maturity of more 
than 60 days (or such longer period as the Treasury may prescribe) 
or (b) is a private activity bond. 

Exception for certain THAN financings 

The bill clarifies that the expenditure determination for the 
"safe harbor" exception to the rebate requirement for certain tax 
or revenue anticipation notes (TRANs), is determined by reference 
to the proceeds, rather than the aggregate face amount, of an issue. 
Thus, under the clarification, net proceeds of an issue are treated 
as expended for the governmental purpose of the issue on the first 
day (after the date of issuance) on which the cumulative cash flow 
deficit to be financed by the issue exceeds 90 percent of the issue 
proceeds. 

This provision is effective for bonds issued after June 30, 1987. 



248 

Exception for small governmental units 

Aggregation of entities 

Under the Reform Act, bonds of a governmental unit with gener- 
al taxing powers may qualify for the special exception from arbi- 
trage rebate only if the governmental unit and all subordinate en- 
tities reasonably expect to issue no more than $5 million of tax- 
exempt bonds (other than private activity bonds) during the calen- 
dar year. The bill clarifies the reference to subordinate entities 
contained in the Reform Act to provide that issuers are to be ag- 
gregated, for purposes of applying the $5-million limitation, as fol- 
lows: 

(a) An issuer, and all entities which issue bonds on behalf of that 
issuer, are to be treated as one issuer. 

(b) If one issuer is subordinate to another entity, but does not 
issue bonds on behalf of the other entity, bonds issued by the subor- 
dinate entity are to be taken into account in applying the $5-mil- 
lion limitation to such other entity. 

(c) Any entity that is formed or, as provided in Treasury regula- 
tions, availed of to avoid the purposes of the $5-million limitation 
and all other entities purporting to benefit from such a device are 
treated as one issuer. 

Treatment of refundings 

The bill clarifies that a current refunding bond is not considered 
in determining whether an issuer otherwise qualifies for the small- 
issuer rebate exception provided the amount of the refunding issue 
does not exceed the outstanding (redeemed) principal amount of 
the refunded bond. Advance refunding bonds are considered in de- 
termining whether an issuer reasonably expects to issue $5 million 
or more in bonds in the same manner as new money bonds. 

Refunding bonds (both current and advance) are themselves eligi- 
ble for this exception from rebate only if (a) the refunded bond 
qualified for, and was taken into account under, the $5 million ex- 
ception when issued,^ (b) the aggregate face amount of the issue of 
which the refunding bond is a part does not exceed $5 million, (c) 
except in the case of refunded issues having a weighted average 
maturity of 3 years or less, the weighted average maturity of the 
refunding bonds does not exceed the weighted average maturity of 
the refunded bonds, and (d) no bond which is part of the refunding 
issue h^s a maturity in excess of 30 years (measured from the date 
of issuance of the refunded bonds). 

Effective date 

The amendments to the small governmental unit rebate excep- 
tion apply generally to bonds issued after June 30, 1987. A special 
rule is provided permitting governmental units qualifying for the 
exception to elect to treat the amendments as if included in the 
Tax Reform Act of 1986 (i.e., as applying to bonds issued after 
August 31, 1986). 



^ Bonds issued before September 1, 1986, that would have qualified for the exception when 
issued had the new arbitrage restrictions applied to the issue of which they were a part are 
treated as satisfying this requirement. 



249 

Exception for certain qualified student loan bonds 

The Reform Act provides a transitional exception from the 
rebate requirement for temporary period earnings of certain quali- 
fied student loan bonds, which earnings are used to pay otherwise 
unreimbursed costs. The bill clarifies that (a) amounts paid by stu- 
dent loan borrowers as interest are not to be taken into account in 
determining whether an issuer is reimbursed for costs under this 
provision, and (b) in the case of bonds eligible for this rebate excep- 
tion, except as provided otherwise in future Treasury regulations, 
amounts earned under the exception also may be taken into ac- 
count in determining yield on the student loans (i.e., interest pay- 
ments by student borrowers at rates generally established by the 
U.S. Department of Education for GSL and PLUS bonds, will not 
be treated as reimbursed under present Treasury regulations). 

9. Prohibition of Federal guarantees 

Present Law 

Interest on Federally guaranteed bonds does not qualify for tax- 
exemption. An exception is provided {inter alia) for any guarantee 
by the Bonneville Power Authority pursuant to the Northwest 
Power Act (16 U.S.C. sec. 839d), as such provision was in effect on 
July 18, 1984, if the bonds are issued before July 1, 1989. 

The District of Columbia generally is not treated as a U.S. in- 
strumentality for purposes of the Federal guarantee prohibition, 
and accordingly is permitted to issue tax-exempt obligations. The 
District is however treated as a U.S. instrumentality in the case of 
certain private activity bonds. Under the Act, these include 
exempt-facility, qualified small-issue, student loan, and qualified 
redevelopment bonds, if such bonds are secured other than as reve- 
nue bonds. 

Explanation of Provision 

The bill clarifies that the exception to the Federal guarantee pro- 
hibition for any guarantee by the Bonneville Power Authority pur- 
suant to the Northwest Power Act (16 U.S.C. sec. 839d), as such act 
was in effect on July 18, 1984 (i.e., the date of enactment of the Tax 
Reform Act of 1984), is a permanent provision. 

The bill further clarifies that issuance of qualified redevelopment 
bonds, by the District of Columbia is not precluded by the prohibi- 
tion on Federal guarantee of tax-exempt bonds solely by virtue of a 
pledge of tax security as required for such bonds under the Code. 

10. Change in use rules 

Present Law 

Under the Reform Act, deductions for interest and certain other 
charges are denied if property financed with private activity bonds 
is used in a manner not qualifying for tax-exempt financing with 
the type of bond involved at any time before the bonds are re- 
deemed. 



250 

Explanation of Provision 

The bill clarifies that users of qualified small-issue bond pro- 
ceeds, like users of the proceeds of other private activity bonds, are 
subject to the new change in use penalties. A change in use of fa- 
cilities financed with qualified small-issue bonds is deemed to occur 
if, for example, post-issuance capital expenditures result in the $10- 
million small-issue size limitation being violated, or if bond-fi- 
nanced facilities are used in a manner specifically prohibited by 
the Code. 

11. Bonds issued by volunteer fire departments 

Present Law 

Certain volunteer fire departments are qualified to issue tax- 
exempt bonds for specified purposes, notwithstanding that the fire 
departments may not be governmental units (or acting on behalf of 
such units) within the meaning of the Code. The Reform Act does 
not specify whether these bonds are private activity bonds. 

Explanation of Provision 

The bill clarifies that bonds issued by certain volunteer fire de- 
partments (sec. 150(e)) are treated as private activity bonds only for 
purposes of the public approval requirement and the prohibition on 
advance refunding of private activity bonds. (These bonds are treat- 
ed as governmental bonds for all other Code purposes.) 

This extension to these bonds of the public approval requirement 
and the prohibition on advance refundings is effective for bonds 
issued after June 30, 1987. 

12. Bonds issued under certain State programs 

Present Law 

The Reform Act authorizes tax-exemption for interest on bonds 
issued as part of the Texas Veterans' Land Bond Program, the 
Oregon Small Scale Energy Conservation and Renewable Resource 
Loan programs, and the Iowa Industrial New Jobs Training Pro- 
gram. The Reform Act permits annual bond volume authority to be 
carried forward for most purposes for which private activity bonds 
may be issued. Carryforwards of annual bond volume authority are 
not addressed for bonds issued pursuant to these four programs. 

Explanation of Provision 

The bill clarifies that bonds issued under the Texas Veterans' 
Land Bond Program, the Oregon Small Scale Energy Conservation 
and Renewable Resource Loan programs, and the Iowa Industrial 
New Jobs Training Program qualify for carryforward elections 
under the applicable private activity bond volume limitations, be- 
ginning with elections for the calendar year 1987 volume limita- 
tions. Further, the bill clarifies that bonds issued under the Iowa 
program are treated as satisfying the limitation on bond maturity 
to 120 percent of the economic life of the assets financed, if the 
weighted average maturity of the issue does not exceed 20 years. 



251 
13. Effective dates 

Present Law 
Mortgage credit certificate (MCC) targeting rules 

The amendments to the mortgage credit certificate (MCC) target- 
ing rules made by the Act apply to MCCs issued to qualifying 
homebuyers after August 15, 1986. 

Rebate requirement for qualified veterans ' mortgage bonds 

Under the Act, the extension of the rebate requirement to all 
tax-exempt bonds generally applies for bonds issued after August 
31, 1986 (in the case of certain bonds that were governmental 
bonds under prior law) or December 31, 1985 (in the case of most 
other bonds). A special effective date applies in the case of bonds 
used to fund certain pools. There is no general transitional excep- 
tion to this requirement. 

Prohibition of advance refunding of pension arbitrage bonds 

The Act expands the arbitrage yield restrictions to apply, inter 
alia, to investments in annuity-type contracts (e.g., pension arbi- 
trage bonds) and other investment-type property. The restriction on 
annuity contract investments applies to bonds (including refunding 
bonds) issued after September 25, 1985. 

Prohibition of abusive devices in connection with advance refund- 
ings 

The Act prohibits the use of any device intended to produce arbi- 
trage profits in connection with an advance refunding, effective 
with respect to bonds issued after December 31, 1986. No inference 
was intended that such devices were permitted before enactment of 
the Act. 

Repeal of qualified mortgage bond policy statement requirement 

Under prior law, issuers of qualified mortgage bonds and MCCs 
were required to submit to the Treasury Department annual state- 
ments explaining their policies in distributing bonds and credits. 
The Act repealed this requirement. 

Explanation of Provisions 
Mortgage credit certificate (MCC) targeting rules 

The bill clarifies that the amendments to the MCC targeting 
rules are effective with respect to elections to trade-in qualified 
mortgage bond authority for authority to issue MCCs, which elec- 
tions are made after August 15, 1986. Thus, credits for which elec- 
tions to trade-in bond authority had been made before August 16, 
1986, but which are actually distributed after that date, continue to 
be subject to the prior-law targeting rules. 

Rebate requirement for qualified veterans ' mortgage bonds 

The bill clarifies that the arbitrage rebate requirement applies to 
current refundings of qualified veterans' mortgage bonds issued 



252 

before January 1, 1986, if such refunding bonds are issued afterj 
June 30, 1987. 

Prohibition of advance refunding of pension arbitrage bonds 

The bill clarifies that the arbitrage restriction on investment in 
annuity contracts prohibits advance refundings (as well as new 
issues) of so-called "pension bonds" after September 25, 1985. Ad- 
vance refunding of such bonds issued under project-specific transi- 
tional exceptions also is prohibited. 

Prohibition of abusive devices in connection with advance refund- 
ings 

The bill clarifies that the Reform Act's prohibition on abusive de- 
vices in connection with advance refundings applies to bonds issued 
after August 31, 1986. As provided in the legislative history accom- 
panying the Reform Act, no inference is intended that these de- 
vices were permitted under prior law. 

Information reporting and public approval requirements 

The bill clarifies that the extensions of the information reporting 
requirement to all bonds and of the public approval requirement to 
all private activity bonds apply to bonds issued after December 31, 
1986. Bonds that were subject to these requirements under prior 
law continued to be so subject if issued between August 15, 1986, 
and December 31, 1986. 

Repeal of qualified mortgage bond policy statement requirement 

The bill clarifies that the repeal of the annual policy statement 
requirement for qualified mortgage bonds was effective for refund- 
ing bonds (as well as new money issues) issued after August 15, 
1986. 

14. Transitional exceptions 

Present Law 

Transitional exception for certain advance refundings 

A transitional exception to various requirements of the Act is 
provided for certain advance refunding bonds. Bonds that were 
IDBs or private loan bonds under prior law may not be advance re- 
funded under this exception. 

Refundings of certain bonds issued pursuant to transitional excep- 
tions 

Bonds issued pursuant to general transitional exceptions 

The Reform Act includes a general transitional exceptions for 
certain bonds for facilities that were "in progress" on September 
25, 1985 (Reform Act sec. 1312), and for certain current refundings 
of bonds originally issued before August 16, 1986 (Reform Act sec. 
1313(a)). 

Bonds issued pursuant to certain project-specific exceptions 

Under the Reform Act, project-specific transitional exceptions 
generally are limited to a specified amount of bonds (Reform Act 



253 

sees. 1316(g) and 1317). The treatment of current refunding issues 
for purposes of these limitations is not specified. 

Treatment for volume limitation purposes 

Advance refundings of certain output facility bonds 

The State private activity bond volume limitations generally are 
effective for bonds issued after August 15, 1986. Transitional excep- 
tions are provided under specified circumstances (Reform Act sec. 
1315). 

A special rule applies to advance refundings of bonds issued 
before August 16, 1986, if the bonds were governmental bonds 
when issued. Under this rule, the refunding bonds are subject to 
the volume limitation, to the extent of the nongovernmental use of 
issue in excess of $15 million, if 5 percent or more of the proceeds 
of the issue was used to finance output facilities (other than facili- 
ties for furnishing water). 

Qualified redevelopment bonds 

Under the Reform Act, bonds issued pursuant to project-specific 
transitional exceptions (Reform Act sec. 1317), and which would not 
have been subject to volume limitations under prior law, are 
exempt from the new private activity bond volume limitation. 

The Reform Act provides project-specific transitional exceptions 
for bonds to finance several redevelopment projects (Reform Act 
sec. 1317(6)). The Reform Act specifies that bonds issued pursuant 
to these exceptions are to be treated as bonds which would not 
have been subject to volume limitations under prior law. (See, 
Reform Act sec. 1315(e).) 

Treatment under alternative minimum tax of bonds issued pursuant 
to transitional exceptions 

Interest on private activity bonds (other than qualified 501(c)(3) 
bonds) issued after August 7, 1986,^ is treated as a preference item 
for purposes of the alternative minimum tax. This treatment does 
not apply to refundings (including a series of refundings) of bonds 
originally issued before August 8, 1986. 

Under a special provision, interest on bonds issued pursuant to 
certain project-specific transitional exceptions (Reform Act sec. 
1317) is not treated as a preference item, if the bonds would not 
have been IDBs or private loan bonds under prior law. Bonds 
issued pursuant to the general transitional exceptions for certain 
"in progress" facilities and for certain refunding bonds, as well as 
exceptions for bonds transitioned under prior tax Acts which excep- 
tions are reenacted (Reform Act sec. 1316(g)), are not eligible for 
this exception. Interest on these bonds is therefore a preference 
item under the alternative minimum tax if the bonds are private 
activity bonds, as defined under present law. 



* This date is extended to August 31, 1986, in the case of certain bonds that were governmen- 
tal bonds under prior law. 



254 

Carryforwards for certain bonds issued pursuant to transitional ex- 
ceptions 

The Reform Act contains no general rule allowing volume cap 
carryforwards for bonds issued pursuant to transitional exceptions. 
Certain transitioned bonds (e.g., bonds which are specifically de- 
scribed as belonging to a category for which carryforward elections 
are permitted under present law) may qualify for carryforward 
elections under the substantive volume limitation rules. 

Project-specific transitional exceptions 

The Reform Act provides transitional exceptions to indicated pro- 
visions for various specifically described projects. 

Explanation of Provisions 
Transitional exception for certain advance refundings 

Under the Reform Act, bonds that were IDBs or private loan 
bonds under prior law do not qualify under the transitional excep- 
tion for certain advance refunding bonds (Reform Act sec. 1313(b)). 
The bill clarifies that the determination of whether a bond was a 
private loan bond is to be made without regard to any exception to 
the private loan bond definition, except the exception for so-called 
"excluded loans" (former sec. 103(o)(2)(C)). Thus (e.g.), IDBs, mort- 
gage revenue bonds and student loan bonds are treated as private 
loan bonds for purposes of this provision, and may not be advance 
refunded under the transitional rule; however, bonds used to make 
loans that enable the borrower to finance a governmental tax or 
assessment of general application for an essential governmental 
function may qualify under the transitional exception provided the 
tax-assessment bonds would not have been IDBs under the prior- 
law definition. 

Refundings of certain bonds issued pursuant to transitional excep- 
tions 

Bonds issued pursuant to general transitional exceptions 

The bill clarifies the conditions under which bonds issued pursu- 
ant to the general transitional exception for certain "in-progress" 
projects (Reform Act sec. 1312) may be currently refunded, while 
continuing to qualify for transitional relief. Such bonds are re- 
quired to meet satisfy both (a) the provisions of the Reform Act 
that apply to bonds issued under the transitional exception for in- 
progress projects (Reform Act sec. 1312(b)(1)), and (b) the provisions 
that apply under the general transitional exception for current re- 
funding bonds (Reform Act sec. 1313(b)(3)). 

Bonds issued pursuant to certain project-specific exceptions 

Where a transitional exception is limited to a specified amount 
of bonds (Reform Act sees. 1316(g) and 1317), the bill clarifies that 
bonds issued pursuant to the exception may be currently refunded, 
under specified circumstances, without the refunding counting 
against this dollar limit. This allowance applies to a refunding (in- 
cluding a series of refundings) of a transitioned bond, provided 
that— 



255 

(a) the weighted average maturity of the refunding issue does not 
exceed the weighted average maturity of the refunded bonds; 

(b) the amount of the refunding bond does not exceed the out- 
standing principal amount of the refunded bond; and 

(c) the refunded bond is redeemed within 90 days of the issuance 
of the refunding bond. 

Treatment for volume limitation purposes 

Advance refundings of certain output facility bonds 

The bill clarifies that the rule subjecting the private use portion 
of advance refundings of pre-August 16, 1986, bonds to the State 
private activity bond volume limitations, if 5 percent or more of 
the net proceeds were used for output facilities, applies notwith- 
standing the general transitional exception contained in Reform 
Act section 1315 for certain bonds that were governmental bonds 
under prior law. 

Qualified redevelopment bonds 

Qualified redevelopment bonds that are the subject of project-spe- 
cific transitional exceptions (Reform Act sec. 1317(6)) generally are 
exempt from the new State volume limitations. The bill clarifies 
that this treatment does not apply to any bonds issued pursuant to 
these exceptions which would have been tax-exempt IDBs (as de- 
fined under the 1954 Code) if the bonds had been issued before 
August 16, 1986. (Bonds for a purpose that would not have qualified 
for tax-exemption under prior law may not be issued under these 
transitional exceptions.) 

This provision is effective for bonds issued after June 10, 1987. 

Treatment under alternative minimum tax of bonds issued pursuant 
to transitional exceptions 

The bill clarifies the treatment under the individual and corpo- 
rate alternative minimum taxes of interest on bonds issued pursu- 
ant to various transitional exceptions. Under this clarification, in- 
terest on bonds issued pursuant to transitional exceptions general- 
ly is not treated as a preference item for purposes of the individual 
or corporate alternative minimum taxes, unless the bonds would 
have been IDBs or private loan bonds if issued on August 7, 1986. 
This clarification applies to bonds issued pursuant to the general 
transitional exceptions for certain bonds (Act sees. 1312 and 1313), 
the continuing exceptions for certain bonds that received transi- 
tional relief under prior tax acts (Act sec. 1316(g)), and project-spe- 
cific transitional exceptions (Reform Act sec. 1317). 

Carryforwards for certain bonds issued pursuant to transitional ex- 
ceptions 

The bill clarifies that carryforward elections under the new State 
volume limitations are permitted for bonds (except qualified small- 
issue bonds) issued pursuant to transitional exceptions (e.g., bonds 
authorized under Reform Act sees. 1312 and 1317). 



256 

Amendments to project-specific transitional exceptions 

The bill clarifies that the new limitations on bond-financing of 
costs of issuance (sec. 147(g)) apply to bonds issued pursuant to 
project-specific transitional exceptions (Reform Act sec. 1317), 
unless otherwise expressly provided. 

The bill further makes various amendments to project-specific 
transitional exceptions contained in the Reform Act. Among these 
amendments is a clarification that bonds authorized to be issued in 
excess of the $150 million limitation on outstanding nonhospital 
bonds for section 501(c)(3) organizations under the project-specific 
transitional exceptions are in addition to any such bonds author- 
ized under a generic transitional exception to the Reform Act 
(Reform Act sec. 1313(b)). Further, issuers may elect which excep- 
tion to apply first — the project-specific exception or the generic ex- 
ception. All transitioned bonds count toward the $150 million limit 
in determining the amount of additional bonds from which a sec- 
tion 501(c)(3) organization may benefit in the future. 



XIV. Trust and Estates; Unearned Income of Certain Minor 
Children; Generation-Skipping Transfer Tax (Sec. 114 of the Bill) 

A. Income Taxation of Trusts and Estates 

1. Grantor treated as holding any power or interest of grantor's 

spouse (sec. 114(a) of the bill, sec. 1401 of the Reform Act, 
and sec. 672 of the Code) 

Present Law 

Under present law, the grantor of a trust is treated as the owner 
of the trust assets if the grantor retained certain powers or inter- 
ests over all or a portion of the trust (sec. 671-678). In such a case, 
the income and deductions of that portion are taxed directly to the 
grantor. In addition, the grantor is treated as the owner of a trust 
if the trust has made certain loans to the grantor of the trust. 

The grantor is treated as holding all powers and interests of the 
grantor's spouse if the grantor's spouse is living with the grantor 
at the time of creation of such interests and powers. 

Explanation of Provision 

The bill provides that the grantor will be treated as holding any 
power or interest that was held by an individual either (1) who was 
the grantor's spouse at the time that the power or interest was cre- 
ated or (2) who became the grantor's spouse subsequent to the cre- 
ation of that power or interest. For this purpose, individuals are 
not considered married if they are legally separated under a decree 
of divorce or of separate maintenance. In addition, the grantor is 
treated as the owner of a trust where the trust makes certain loans 
to the grantor's spouse. 

2. Limitations to reversionary interest rule exceptions (sec. 114(b) 

of the bill, sec. 1402 of the Reform Act, and sec. 673 of the 
Code) 

Present Law 

The grantor is treated as the owner of the trust property were 
the grantor or the grantor's spouse has a reversionary interest 
whose value is more than 5 percent of the value of the trust at the 
time of the inception of the trust. 

Explanation of Provision 

The bill provides that, in determining whether an reversionary 
interest has a value in excess of 5 percent of the trust, it will be 
assumed that any discretionary powers are exercised in such a way 
as to maximize the value of the reversionary interest. In addition, 
the bill reenacts a provision of prior law which provides rules for 

(257) 



258 

postponements of the date of a reversionary interest. This provision 
was deleted by the Act, but is necessary where the date of the re- 
versionary interest is after the life of an individual and that date is 
later postponed. ^ 

3. Taxable year of trusts (sec. 114(c) of the bill and sec. 1403 of 

the Reform Act) 

Present Law 

Trusts are required to use a calendar year as their taxable year, 
effective for taxable years beginning after December 31, 1986. The 
taxable income of any beneficiary of a trust that is attributable to 
the trust's short taxable year arising from a required change of its 
taxable year to a calendar year is to be included in the benefi- 
ciary's income over a four year period beginning with the year of 
change. 

Explanation of Provision 

The bill provides that the four year spread from a required 
change of a taxable year also is available to beneficiaries of chari- 
table remainder trusts (described in sec. 664). 

4. Estimated taxes of trusts and estates (sec. 114(d) of the bill, sec. 

1404 of the Reform Act, and sec. 6654 of the Code) 

Present Law 

Under present law, trusts, as well as estates for any taxable year 
ending 2 or more years after the date of the decedent's death, are 
required to pay estimated taxes in the same manner as individuals. 
In addition, the trustee may elect, in substance, to distribute any 
excess estimated payments to the trust beneficiaries if the trustee 
so elects within 65 days of the close of the trust's taxable year on 
the trust's tax return for that year. 

Explanation of Provision 

The bill provides that the individual estimated tax provisions do 
not apply to a trust subject to tax under section 511 or to any pri- 
vate foundation. 1 In addition, the bill clarifies that the election to 
distribute excess estimated tax payments to beneficiaries need not 
be made on the tax return for the trust for the preceding year, but 
may be made in a manner prescribed by the Secretary of the 
Treasury. 



* See section 115(h) of the bill, clarifying the application of the corporate estimated tax re- 
quirements to these organizations. 



B. Taxation of Unearned Income of Minor Children (Sec. 114(e) 
of the bill, sec. 1411 of the Reform Act, and sees. 1 and 59 of the 
Code) 

Present Law 

The unearned income of a child under age 14 in excess of $1,000 
is taxed to the child at the highest marginal rate of the child's par- 
ents. This tax is determined by calculating the additional tax that 
the parents would pay if the parents' income included the un- 
earned income of the child in excess of $1,000. In making this cal- 
culation, the amount of the parents' deductions and credits are not 
affected by the inclusion of any of the child's unearned income in 
the parents' income. The Secretary of the Treasury is to issue regu- 
lations providing for the application of these rules were the minor 
child or his parents is subject to the alternative minimum tax. 

Where an individual transfers appreciated property to a trust 
and the trust disposes of such property within 2 years of the trans- 
fer, the tax on the built-in gain at the time of the transfer to the 
trust is determined at the highest marginal rate of the transferor 
for the year of sale (sec. 644). 

Explanation of Provision 

Computation of child's tax where parents' rates are used to deter- 
mine tax of trust 

The bill provides that, where parents whose marginal tax brack- 
ets are being used to determine both the income tax of a trust 
under section 644 and income tax of their minor children under 
section l(i), the tax of the trust is determined first without regard 
to the income of the minor child and then the tax of the minor 
child is to be determined second by including the gain of the trust 
which is taxable under section 644 in the income of the parent. The 
bill also provides that the determination of the tax of the child 
does not affect that amount of any "exclusion," as well as any de- 
duction or credit, of the parents. 

Alternative minimum tax 

The bill also provides that the alternative minimum tax imposed 
on the net unearned minimum taxable income of a child under 14 
years of age will not be less than the alternative minimum tax 
which would have been imposed on the parents had that income 
been included in the parents' alternative minimum taxable income. 
The amount of minimum tax which would have been imposed on 
the parents is computed by including the child's net unearned min- 
imum taxable income in the alternative minimum taxable income 
of the parents, and by increasing the parents' regular tax by the 
amount of the child's regular tax imposed on the net unearned 

(259) 



260 

income of the child. For this purpose, net unearned minimum tax- 
able income means net unearned income (i.e., unearned income in 
excess of $1,000) computed by taking into account the preferences 
and adjustments provided in sections 56, 57 and 58. 

For example, assume that the child's net unearned income (as 
defined in section l(i)(4)) is $10,000 and the unearned minimum 
taxable income (as defined in section 59(j)(3) as added by the bill) is 
$20,000, by reason of the child having $10,000 of tax-exempt inter- 
est on newly issued private activity bonds. Assume that the parent 
are subject to the alternative minimum tax for the taxable year 
and that the parents' marginal rate for purposes of the regular tax 
is 28 percent. Under the rules of section l(i), the child's regular tax 
on the net unearned income is $2,800. The child is not subject to 
the alternative minimum tax (determined without regard to this 
provision) by reason of the $30,000 exemption amount. Under the 
bill, the child's minimum tax will be $1,400 (21 percent of $20,000 
($4,200) less 28 percent of $10,000 ($2,800)). If, however, the parents 
would not have been subject to the alternative minimum tax 
(taking into account the net unearned minimum taxable income 
and the regular tax of the child) because their regular tax exceeded 
their tentative minimum tax, no minimum tax would be imposed 
on the child. 



C. Generation-Skipping Transfer Tax 

1. Overlap of direct skips and taxable termination and distribu- 

tions (sec. 114(f)(3) of the bill, sec. 1431 of the Reform Act, 
and sec. 2612 of the Code) 

Present Law 

A "direct skip" is defined as a transfer subject to estate or gift 
tax of an interest in property to a skip person. A "taxable termina- 
tion" is defined as a termination of an interest in property held in 
trust if (1) there is no nonskip person who has an interest in the 
trust after the termination or (2) at no time after the termination 
may a distribution be made from that trust to a nonskip person. A 
"taxable distribution" is defined as a distribution from a trust to a 
skip person (other than a taxable termination or a direct skip). 

Explanation of Provision 

The bill provides that, where a transfer meets the definitions of a 
direct skip and a taxable termination or distribution, the transac- 
tion will be treated as a direct skip. For example, where an individ- 
ual transfers property into a trust that is to pay income to that in- 
dividual for his life and, after that individual's death, to pay the 
remainder to that individual's grandchild, there is both a direct 
skip and a taxable termination under present law at the death of 
that individual. Under the bill, there is a direct skip from the indi- 
vidual to the individual's grandchild (and no taxable termination) 
at the time of that individual's death. 

2. Treatment of charitable interests (sec. 114(f)(4) of the bill, sec. 

1431 of the Reform Act, and sec. 2642 of the Code) 

Present Law 

Under present law, the amount of the generation-skipping trans- 
fer tax is determined by multiplying the amount involved by the 
"applicable rate." The applicable rate basically is the top Federal 
estate tax rate multiplied by the proportion of the property in the 
trust that is subject to tax, determined at the time the trust is es- 
tablished. The present value of charitable interests are deducted in 
determining the amount of the trust that is subject to tax.^ The 
i effect of deducting the present value of charitable interest in deter- 



2 Technically, the "applicable rate" is the product of the maximum Federal estate tax rate 
and the "inclusion ratio." The "inclusion ratio is the excess of 1 over the "applicable fraction." 
The "applicable fraction" is a fraction the numerator of which is the portion of the $1 million 
exemption allowed each individual that is allocated to this transfer and the denominator of 
which is the value of the property transferred to the generation-skipping trust reduced by (1) 
any Federal and State estate or death taxes recovered from the trust and (2) a charitable deduc- 
tion for the value of any charitable interest in the trust at that time. 

(261) 



262 

mining the applicable rate is to exempt property passing to a non- 
charitable person from the generation-skipping transfer tax, even if 
the charitable interest has expired at the time of the imposition of 
the generation-skipping transfer tax. For example, where property 
is placed in trust to pay an annuity to charity for the life of an 
individual, A, with the remainder to go to the transferor's grand- 
child, the amount of the generation-skipping transfer tax imposed 
at the death of A is reduced by the charity's annuity interest even 
though charity no longer has any interest in the trust. 

Explanation of Provision 

The bill deletes the provision that removes the value of any char- 
itable interests in determining the "applicable rate." Thus, in the 
case described above, the amount of the generation-skipping trans- 
fer tax will be determined by reference to the value of net assets 
placed in trust which is not sheltered by any of the $1 million ex- 
emption allocated to the trust. 

Nonetheless, in order to insure that no generation-skipping 
transfer tax is imposed on property actually passing to charity, the 
bill provides that the amount that would be subject to a genera- 
tion-skipping transfer tax is reduced by the value of any charitable 
interests at the time the generation-skipping tax is imposed. For 
example, where property is placed in a trust which is to pay an an- 
nuity to the transferor's child for life, then an annuity to the trans- 
feror's grandchild for life, with the remainder to go to charity at 
the grandchild's death, the amount subject to the generation-skip- 
ping transfer tax at the child's death is reduced by the present 
value of the charitable remainder interest determined as of the 
child's death. 

These changes are effective for transfers made after June 10, 
1987. 

3. Special rule for determination of inclusion ratio where inter 
vivos transfers are includible in transferor's gross estate (sec. 
114(f)(5) of the bill, sec. 1431 of the Reform Act, and sec. 2642 
of the Code) 

Present Law 

The inclusion ratio is used to establish the rate of tax which is 
imposed on the generation-skipping transfer. It is the ratio the nu- 
merator of which is the amount of the $1 million exemption al- 
lowed to every individual that the transferor has allocated to a par- 
ticular transfer and the denominator of which is the value of the 
property transferred to the trust reduced by any Federal or State 
death taxes recovered from the trust and the present value of any 
charitable interests in the trust. ^ Where any of the $1 million ex- 
emption is allocated to property transferred at or after the death of 
the transferor, the value of the property is its value for Federal 
estate tax purposes. Where any of the $1 million exemption is allo- 



^ The bill removes the allowance of the charitable deduction for purposes of determining the 
inclusion ratio and allows a separate charitable deduction in computing the amount subject to 
the generation-skipping transfer tax. 



263 

cated on a timely filed gift tax return, the value of the property is 
its value for Federal gift tax purposes. Where any of the $1 million 
is allocated during the lifetime of the transferor but not on a 
timely filed gift tax return, the value of the property is determined 
at the time that the allocation is filed with the Internal Revenue 
Service. 

Explanation of Provision 

The bill provides that any allocation of any portion of the trans- 
feror's $1 million exemption to property that is transferred by the 
transferor during his lifetime, but would be includible in the trans- 
feror's gross estate (other than pursuant to sec. 2035) is not effec- 
tive until the death of the transferor and the value of property for 
purposes of determining the inclusion ratio shall be its value for 
Federal estate tax purposes. Where any such property is subse- 
quently transferred in such a manner that it would not be includ- 
ible in the gross estate of the transferor (e.g., where the property is 
distributed by a trust to the transferor's grandchild), the distribu- 
tions to skip persons are treated as direct skips, any allocation of 
the $1 million exemption is effective at that time, and the value of 
the property is its value at that time. 

4. Definition of skip person involving trusts (sec. 114(f)(6) of the 
bill, sec. 1431 of the Reform Act, and sec. 2613 of the Code) 

Present Law 

Under present law, a "skip person" is defined to mean either (1) 
a person assigned to a generation that is two or more generations 
below that of the transferor or (2) a trust all the interests of which 
are held by such persons and at no time can make distributions to 
persons assigned to a generation less than two generations below 
that of the transferor (sec. 2613(a)). Also under present law, a trust 
generally is a person (sec. 7701(a)(1)). 

If an estate, trust, partnership, corporation, or other entity has 
an interest in property, each individual having a beneficial interest 
in such entity is treated as having an interest in that property and 
is assigned to a generation under normal generation assignment 
rules consistent with that beneficial interest (sec. 2651(e)(2)). 

Explanation of Provision 

The bill clarifies the definition of a "skip person" by providing 
that a skip person must be a "natural person" whose generation 
assignment is two or more generations below that of the transferor 
(i.e., category (1), above). In addition, the bill provides that the de- 
termination of whether a trust is a "skip person" (i.e., category (2), 
above) is to be determined without regard to the entity look- 
through rules as they apply to trusts. 



264 

5. Disregard of support obligations as an interest (sec. 114(f)(7) of 
the bill, sec. 1431 of the Reform Act, and sec. 2652 of the Code) 

Present Law 

In order to determine whether there is a taxable termination 
(sec. 2612(a)), whether property is transferred to a skip person (sec. 
2612(c)), and whether property qualifies for the $2 million exemp- 
tion for transfers to grandchildren, it is necessary to determine 
which persons have an "interest" in the trust. A person generally 
is treated as having an interest held in trust if that person has a 
right (other than a future right) to receive income or corpus from a 
trust or is a permissible current recipient of income or corpus from 
the trust. 

Description of Provision 

The bill provides that any income or corpus of the trust that may 
be used to satisfy any obligation of support arising by reason of 
State law is to be be disregarded in determining whether a person 
has an interest in a trust, unless the trust instrument expressly 
provides that the trust assets may be used to discharge an obliga- 
tion of support. Thus, a parent generally is not treated as having 
an interest in a trust or trust equivalent by reason of any powers 
that the parent may have under the State law comparable to the 
Uniform Gifts to Minors Act, or that the parent may have as a 
guardian for a child of the parent. On the other hand, a parent 
would be treated as having an interest in the trust if the trust in- 
strument provided that the trust assets would be used to discharge 
the support obligations of that parent. 

6. Taxation of multiple skips (sec. 114(f)(8) of the bill, sec. 1431 of 

the Reform Act, and sec. 2653 of the Code) 

Present Law 

Under present law, there is no generation-skipping transfer tax 
on what otherwise would be a direct skip where property is trans- 
ferred from the transferor to the grandchild of the transferor or a 
trust for the benefit of such a grandchild if the parent of the 
grandchild is deceased at the time of the transfer (sec. 2612(c)). This 
is accomplished by deeming the generation assignment of the 
grandchild to "step up" to the generation of the child. 

Also under present law, where property held in trust has been 
the subject of a generation-skipping transfer tax and the property 
remains in trust, the transferor of the property remaining in trust 
for purposes of subsequent applications of the generation-skipping 
transfer tax is deemed to be in the generation one higher than the 
generation of the beneficiary or beneficiaries with the highest gen- 
eration. In effect, the generation of the transferor "drops down" to 
one generation older than that of the eldest beneficiaries of the 
trust. There is no "drop down" of the transferor where the proper- 
ty is exempt from the generation skipping tax by reason of the pre- 
deceased child exception of section 2612(c). Thus, if property is 
transferred by a grandparent to a trust for the exclusive benefit of 
the transferor's grandchild, distributions from the trust to the 



265 

grandchild would be taxable distributions even though the grand- 
child's parents were deceased when the trust was created. 

[ Explanation of Provision 

' The bill provides that the generation "drop-down" rule of section 
2653(a) applies where there would have been a generation-skipping 
transfer but for the predeceased child rule of section 2612(c). Thus, 
where a grandparent transfers property to a trust which is to pay 
income to the grandparent's grandchild for life, distributions to the 
grandchild would not be taxable distributions if the grandchil- 
dren's parents were deceased at the time of the transfer to the 
trust. 

7. Certain interests disregarded (sec. 114(f)(9) of the bill, sec. 1431 

of the Reform Act, and sec. 2652(c)(2) of the Code) 

Present Law 

The determination of whether a trust is a generation-skipping 
trust depends upon whether a beneficiary has an "interest" in the 
trust. Under present law, a person generally has an interest in 
property if that person has a right (other than a future right) to 
receive income or corpus from the trust or is a permissible current 
recipient of income or corpus from the trust. Nonetheless, present 
law provides that an interest that is used primarily to postpone or 
avoid the generation-skipping transfer tax is disregarded in apply- 
ing the generation-skipping transfer tax. 

Explanation of Provision 

The bill clarifies the rule of present law that disregards interests 
primarily used to postpone or avoid the generation-skipping trans- 
fer tax by removing any indication that the interest to be disre- 
garded must be nominal and by providing that the rule applies if 
the primary purpose of the interest is to avoid any generation-skip- 
ping transfer tax. For example, if a transferor placed property in 
trust which is to pay income to a great grandchild for a relatively 
short period, then income to a grandchild for life, with remainder 
going back to a great grandchild, in order to avoid a second imposi- 
tion of the generation-skipping transfer tax, the income interest of 
the great grandchild would be disregarded so that there would be a 
generation-skipping transfer tax at the death of the grandchild. 
That interest would be disregarded even though distributions to 
the grandchild and great grandchild are taxable distributions 
under present law. 

8. Definition of transferor (sec. 114(f)(10) of the bill, sec. 1431 of 

the Reform Act, and sec. 2652 of the Code) 

Present Law 

The term "transferor" is defined to mean the decedent, in the 
case of a transfer of a kind subject to the Federal estate tax, or the 
donor, in the case of a transfer of a kind subject to the Federal gift 
tax. In some cases, it is possible for property to be subject to Feder- 
al estate or gift tax even though there is no transfer of such prop- 



73-917 O - 87 - 10 



266 

erty under local law at such time. For example, in the case of a 
trust which is to pay income to the transferor for life, then income 
to the transferor's child for life, remainder to the transferor's 
grandchild, the property is includible in the gross estate of the 
transferor, even though there is no transfer of the trust assets 
under local law at the time of the transferor's death. 

Explanation of Provision 

The bill clarifies the definition of "transferor" by providing that 
a person is treated as the transferor of any property included in 
the gross estate of that person or which that person has made a 
gift. Thus, a person can be a transferor even though there is not a 
transfer of property under local law. The transferor is treated as 
transferring any property with respect to which that person is the 
transferor. 

9. Regulatory authority to prescribe rules dealing with trust 

equivalents (sec. 114(f)(ll) of the bill, sec. 1431 of the Reform 
Act, and sec. 2663 of the Code) 

Present Law 

The generation-skipping transfer tax is imposed on generation- 
skipping trusts. For this purpose, a trust is any arrangement (other 
than an estate) which has substantially the same effect as a trust. 
Examples of such arrangements include life estates and remain- 
ders, estates for years, and insurance and annuity contracts. 

Explanation of Provision 

The bill provides the Secretary of the Treasury with authority to 
prescribe regulations modifying the generation-skipping transfer 
tax rules generally applicable to trusts in the case of trust equiva- 
lents. For example, where the generation-skipping arrangement is 
in the form of an insurance or annuity contract, it is possible that 
the Secretary of the Treasury may exercise the authority granted 
by this section of the bill to provide that the beneficiary of the in- 
surance or annuity contract pay any generation-skipping transfer 
tax. 

10. Clarification of inclusion ratio where all transfers to the gen- 
eration-skipping trust qualify for the gift tax exclusions (sec. 
114(f)(12) of the bill, sec. 1431 of the Reform Act, and sec. 2642 
of the Code) 

Present Law 

In the case of direct skips, the inclusion ratio with respect to 
transfers which qualify for the annual $10,000 gift tax exclusion 
(under section 2503(b)) or the gift tax exclusion for medical and 
educational costs (under sec. 2503(c)) is zero. In the case of taxable 
terminations and taxable distributions from a generation-skipping 
trust, the determination of the inclusion ratio generally is not af- 
fected by such nontaxable transfers. Nonetheless, in the case of 
any nontaxable transfer to a generation-skipping trust which is the 
first transfer to the trust, the inclusion ratio for that trust is zero. 



267 

Explanation of Provision 

The bill clarifies that a generation-skipping trust has an inclu- 
sion ratio of zero where the initial transfer to the trust is a wholly 
nontaxable gift. For example, assume that an individual transfers 
property which wholly qualifies for the $10,000 annual gift tax ex- 
clusion to a newly created generation-skipping trust in 1988. The 
bill clarifies that the inclusion ratio applicable to that trust is zero. 
Now assume that the individual transfers additional property 
which wholly qualifies for the $10,000 annual gift tax inclusion to 
the trust in 1989. Since the transfer in 1989 is not taken into ac- 
count in determining the inclusion ratio under section 2642(c)(2)(A), 
the inclusion ratio of the trust after that transfer remains zero. 

11. Generation assignment of governmental entities (sec. 
114(f)(13) of the bill, sec. 1431 of the Reform Act, and sec. 
2651(e)(3) of the Code) 

Present Law 

In general, persons who are related to the transferor are as- 
signed to a generation based upon their relationship to the trans- 
feror. Persons who are not related to the transferor are assigned to 
a generation based upon the difference in age between that person 
and the transferor. Charitable organizations (described in sees. 
511(a)(2) and (b)(2)) are assigned to the same generation as that of 
the transferor. 

Explanation of Provision 

The bill provides that any governmental entity is assigned to the 
same generation as that of the transferor. The rule applies to all 
governmental entities, including the United Stated Government, 
the government of any State, and the government of any foreign 
country. 

12. Basis of property after a taxable termination (sec. 114(f)(14) of 

the bill, sec. 1431 of the Reform Act, and sec. 2654 of the 
Code) 

Present Law 

Where property is subject to a generation-skipping transfer tax, 
the basis of the property immediately after the generation-skipping 
transfer tax generally is its basis immediately before the imposi- 
tion of the generation-skipping transfer tax increased (but not in 
excess of the property's fair market value at such time) by the por- 
tion of the generation-skipping transfer tax attributable to any ap- 
preciation in the property at such time. Nonetheless, where proper- 
ty that is entirely subject to a generation-skipping transfer tax at 
the same time as and as a result of the death of an individual, the 
basis of the property immediately after the imposition of the gen- 
eration-skipping transfer tax generally is its fair market value at 
such time. Where only a portion of the property is subject to the 
generation-skipping transfer tax (because the inclusion ratio is less 
than 1), any increase in basis to the property's fair market value 
basically is limited to the portion of the property subject to the 



268 

generation-skipping transfer tax (i.e., the amount of appreciation in; 
the property multiplied by the inclusion ratio). 

Explanation of Provision 

The bill provides that where the basis of property that has been 
subject to a generation-skipping transfer tax is to be determined by 
reference to its fair market value (because the generation-skipping 
transfer tax occurs at the same time as and as a result of the death 
of an individual) and the inclusion ratio is less than 1, any decrease 
in basis (as well as any increase in basis) is limited by the decrease 
in the 78value of such property multiplied by the inclusion ratio, 

13. Treatment of single trust as multiple trusts (sec. 114(f)(15) of 

the bill, sec. 1431 of the Reform Act, and sec. 2654 of the 
Code) 

Present Law 

The generation-skipping transfer tax is imposed on direct skips 
and taxable terminations and taxable distributions from a genera- 
tion-skipping trust. The impact of the generation-skipping transfer 
tax sometimes depends upon whether assets are transferred in one 
trust or in more than one trust. For example, where transfers that 
qualify for the $10,000 annual exclusion are made to a generation- 
skipping trust that has an inclusion ratio greater than zero, some 
or all of such transfers may be subject to a generation-skipping 
transfer tax as a taxable termination or taxable distribution, even 
though such transfers would not be subject to the generation-skip- 
ping transfer tax if they were made to a separate trust. 

Explanation of Provision 

The bill provides that a single trust may not be treated as two 
separate trusts for purposes of the generation-skipping transfer 
tax. 

14. Effective date of the revised generation-skipping transfer tax 
(sec. 114(g)(1) and (2) of the bill and sec. 1433 of the Reform 
Act) 

Present Law 

The revised generation-skipping transfer tax generally applies to 
transfers made after the date of enactment of the Reform Act (Oc- 
tober 22, 1986). In addition, the revised generation skipping trans- 
fer tax applied to inter vivos transfers made after September 25, 
1985. 

The generation-skipping transfer tax does not apply, however, 
to— 

(1) inter vivos transfers made before September 26, 1985, 

(2) trusts that were irrevocable before September 26, 1985, except 
for additions of corpus to such trusts after September 25, 1985, 

(3) testamentary transfers made pursuant to will in existence 
before the date of enactment of the Reform Act (October 22, 1986) 
if the decedent died before January 1, 1987, and 



269 

(4) transfers under a trust to the extent that such trust consists 
of property included in the gross estate of the decedent or which 
are direct skips which occur by reason of the death of any decedent 
if the decedent was incompetent on the date of enactment of the 
Reform Act (October 22, 1986) and at all times thereafter until 
death. 

Explanation of Provision 

The bill clarifies that the grandfather of irrevocable trusts cre- 
ated before September 25, 1985, applies whether or not income de- 
rived from corpus contributions before September 26, 1985, is dis- 
tributed or accumulated. The bill also provides that the grandfa- 
ther of transfers made pursuant to wills in existence on the date of 
enactment of the Reform Act (October 22, 1986) if the decedent dies 
before January 1, 1987, also applies to transfers pursuant to revo- 
cable trusts which were in existence on the date of enactment of 
the Reform Act (October 22, 1986) if the decedent dies before Janu- 
ary 1, 1987. Finally, the bill clarifies that the decedent must have 
been incompetent on Septerber 25, 1985, and at all times thereafter 
until death, in order for direct skips or transfers of assets includ- 
ible in the decedent's gross estate to be exempt from generation- 
skipping transfer taxes. 

15. $2 million exemption (sec. 114(g)(3) of the bill and sec. 1433 of 

the Reform Act) 

Present Law 

The revised generation-skipping transfer tax on direct skips does 
not apply to transfers before January 1, 1990, from a transferor to 
a grandchild of the transferor to the extent that the aggregate 
transfers from that transferor to that grandchild do not exceed $2 
million. An election may be made to treat inter vivos and testa- 
mentary contingent transfers in trusts for the benefit of a grand- 
child as direct skips if (1) the transfers occur before the date of en- 
actment of the Reform Act (October 22, 1986), and (2) the transfers 
would be direct skips except for the fact that the trust instrument 
provides that, if the grandchild dies before vesting of the interest 
transferred, the interest is transferred to the grandchild's heirs 
(rather than the grandchild's estate). Transfers treated as direct 
skips as a result of this election are subject to Federal gift and 
estate tax on the grandchild's death in the same manner as if the 
contingent gift over had been to the grandchild's estate. 

Explanation of Provision 

The bill clarifies the application of the $2 million exemption in 
three respects. First, the bill clarifies that a transfer to a trust is 
treated as a transfer to a grandchild if (1) no amount may be dis- 
tributed to any person other than that grandchild during the life of 
that grandchild, (2) the assets will be includible in the gross estate 
of the grandchild if the grandchild dies before the termination of 
the trust, and (3) all of the income of the trust after the child has 
reached age 21 must be distributed to the grandchild not less often 
than annually. 



270 

Second, the bill clarifies that trusts which are eligible for the $2 
million exemption are treated as if that trust had been subject to 
the generation-skipping transfer tax and, consequently, that distri- 
butions out of a trust to such a grandchild are not treated as tax- 
able distributions. 

Third, the bill amends the special rules applicable to transfers in 
trust before the date of enactment of the Reform Act (sec. 1433(d) 
of that Act) by (a) clarifying that transfers to such trusts are treat- 
ed as transfers to a grandchild (and, therefore, eligible for the $2 
million exclusion) and (b) providing that the executor of the grand- 
child can recover the additional estate taxes imposed upon the 
estate of the grandchild by reason of the election from that person 
or persons receiving the property unless the will of the grandchild 
provides otherwise. 



XV. Compliance and Tax Administration Provisions (Sec. 115 of 

the Bill) 

1. Nominee reporting by partnerships (sec. 115(a) of the bill, sec. 

1501 of the Reform Act, and sec. 6724(d)(2)(B) of the Code) 

Present Law 

Present law requires that any person holding an interest in a 
partnership as a nominee for another person must furnish to the 
partnership the name and address of that other person (along with 
any additional information required by regulations) (Code sec. 
6031(c)). Failure by the nominee to provide this information to the 
partnership is not subject to the general penalty for failure to file 
information reports as required. 

Explanation of Provision 

The bill provides that a nominee's failure to supply the required 
information to the partnership is subject to the general penalty for 
failure to furnish payee statements (sec. 6722). This penalty is $50 
per failure, up to a maximum of $100,000 per calendar year. 

2. Negligence and fraud penalties (sec. 115(b) of the bill, sec. 1503 

of the Reform Act, and sees. 6013(b)(5), 6601(e), and 6653 of 
the Code) 

Present Law 

Taxpayers are subject to penalties if any part of an underpay- 
ment of tax is due to negligence or fraud (Code sec. 6653). Both of 
these penalties have two components. The first component of each 
penalty is the basic penalty (5 percent of the entire understatement 
in the case of negligence, 75 percent of the portion attributable to 
fraud in the case of fraud). The second component of each penalty 
is an amount equal to one-half the interest payable on the portion 
of the underpayment attributable to either negligence or fraud (as 
the case may be), for the period beginning on the last day pre- 
scribed for payment of the underpayment (without regard to any 
extension) and ending on the date of the assessment of the tax (or 
the date of payment of the tax if that date is earlier). Interest on 
the negligence and fraud penalties generally begins on the date 
these penalties are assessed, rather than the last date prescribed 
for filing the return to which the penalty relates. 

Explanation of Provision 

The bill repeals the second, time-sensitive components of both 
the negligence and fraud penalties. The bill instead imposes inter- 
est on these penalties from the last date prescribed for filing the 

(271) 



272 I 

return to which the penalty relates. The bill also improves the co- 
ordination of these penalties with the provision permitting a couple 
to file a joint return after filing a separate return (Code sec. 
6013(b)). 

These provisions apply to returns the due date for which (deter- 
mined without regard to extensions) is after December 31, 1987. 

3. Penalty for substantial understatement of tax liability (sec. 

115(c) of the bill and sec. 1504 of the Reform Act) 

Present Law 

A taxpayer who substantially understates income tax for any 
taxable year must pay a penalty (Code sec. 6661). The Tax Reform 
Act of 1986 provided that this penalty is to be 20 percent of the 
amount of the underpayment of tax attributable to the understate- 
ment. This was effective for returns the due date of which (deter- 
mined without regard to extensions) is after December 31, 1986. 

After considering the Reform Act, Congress considered the Omni- 
bus Budget Reconciliation Act of 1986 (P.L. 99-509). That Act^ in- 
creased this penalty to 25 percent of the underpayment, effective 
for penalties assessed after the date of enactment of that Act. Al- 
though Congress considered the Reform Act prior to considering 
the Omnibus Budget Reconciliation Act, the Omnibus Budget Rec- 
onciliation Act was enacted one day before the date of enactment 
of the 1986 Act. 2 

Explanation of Provision 

The bill provides that the increase in the substantial understate- 
ment penalty to 25 percent made by the Omnibus Budget Reconcili- 
ation Act of 1986 shall take effect as if the Tax Reform Act of 1986 
were enacted on the day before the date of enactment of the Omni- 
bus Budget Reconciliation Act of 1986. 

4. Differential interest rate (sec. 115(d) of the bill, sec. 1511 of the 

Reform Act, and sec. 6621 of the Code) 

Present Law 

The interest rate that taxpayers pay to the Treasury on under- 
payments of tax is one percentage point higher than the interest 
rate the Treasury pays to taxpayers on overpayments of tax. 

Explanation of Provision 

The bill corrects several cross-references to the provisions uti- 
lized to determine these rates. 



1 See sec. 8002 of the Omnibus Budget Reconciliation Act of 1986. 

2 The Omnibus Budget Reconciliation Act of 1986 was enacted on October 21, 1986; the 1986 
Act was enacted on October 22, 1986. 



273 

5. Information reporting by brokers (sec. 115(e) of the bill, sec. 

1521 of the Reform Act, and sec. 6045 of the Code) 

Present Law 

Persons doing business as a broker must report on specified types 
of transactions they effect for customers. Generally, reporting is re- 
quired on sales of securities, commodities, regulated futures con- 
tracts, precious metals, and real estate. 

Explanation of Provision 

The bill provides that a person shall not be treated as a broker 
with respect to activities consisting of managing a farm on behalf 
of another person. This exempts farm managers from the require- 
ment of filing a Form 1099-B with respect to their farm manage- 
ment activities. This information must be filed by these farm man- 
agers on a Schedule F, where it is provided in a more useful 
format. Consequently, filing this information on a Form 1099-B is 
duplicative. This provision is effective as if included in the Tax 
Equity and Fiscal Responsibility Act of 1982 (which generally im- 
posed these information reporting requirements). 

The bill also makes it unlawful for any real estate broker (who is 
generally defined as the person responsible for closing the real 
estate transaction) to charge separately any customer for comply- 
ing with the information reporting requirements with respect to 
real estate transactions. This provision is effective on the date of 
enactment of the bill. 

6. Information reporting on persons receiving contracts from cer- 

tain Federal agencies (sec. 115(f) of the bill, sec. 1522 of the 
Reform Act, and sec. 6050M of the Code) 

Present Law 

Present law requires that the head of each Federal executive 
agency file an information return with the IRS indicating the 
name, address, and taxpayer identification number of each person 
with which the agency enters into a contract. The agency must also 
report any additional information required under Treasury regula- 
tions. There is no exception from this information reporting in 
present law for contracts involving national security, confidential 
law enforcement, or foreign counterintelligence activities. 

Explanation of Provision 

The bill excepts specified types of contracts from the general in- 
formation reporting requirements applicable to Federal executive 
agencies, and makes those types of contracts subject to a different 
form of information reporting. 

There are two types of contracts between a Federal executive 
agency and another person that are subject to these special rules. 
The first is a contract where either the fact of the existence of the 
contract or the subject matter of the contract has been classified. 
This is accomplished by designating and clearly marking or clearly 
representing, pursuant to the provisions of Federal law or an Exec- 



274 

utive order, ^ that the contract or the subject matter of the contract 
requires a specific degree of protection against unauthorized disclo- 
sure for reasons of national security. The second type of contract 
subject to the special rules is a contract involving a confidential 
law enforcement or foreign counterintelligence activity. In order to 
be eligible for these special rules, the head of the Federal executive 
agency (or his designee) must determine in writing that filing the 
information return generally required of Federal executive agen- 
cies would interfere with the effective conduct of a confidential law 
enforcement or foreign counterintelligence activity. This determi- 
nation must be made pursuant to regulations issued by the Federal 
executive agency making the determination. This second type of 
contract involves primarily undercover operations (including sites 
for undercover operations) and informants. 

These two types of contracts are subject to special information 
reporting requirements, and are exempted from the general infor- 
mation reporting requirements of section 6050M. The special infor- 
mation reporting requirements are that the IRS must first request 
that the Federal executive agency acknowledge whether that 
agency has entered into a contract with a particular person, who 
must be identified in the IRS request. The Federal executive 
agency must in response acknowledge whether it has entered into 
a contract with the specified person. If it has, it must provide to 
the IRS with respect to that person the information required to be 
reported under section 6050M. In addition, the agency must pro- 
vide whatever additional information the agency and the Treasury 
agree is appropriate. The term "person" has the meaning given in 
section 7701(a)(1). 

It is contemplated that the information provided by Federal exec- 
utive agencies to the IRS under these special rules might need to 
be provided only to certain IRS employees, such as those with secu- 
rity clearances. If this is necessary, it is also contemplated that the 
Federal executive agencies will cooperate with the IRS in expedi- 
tiously obtaining clearance for the IRS employees. 

This provision is effective as if included in the 1986 Act (i.e., on 
January 1, 1987). 

7. Information reporting on royalties (sec. 115(g) of the bill, sec. 
1523 of the Reform Act, and sec. 6676 of the Code) 

Present Law 

Persons who make payments of royalties aggregating $10 or 
more to any person in a calendar year must provide an information 
report on the royalty payments to the IRS (as well as provide a 
copy to the payee) (Code sec. BOSON). 

Explanation of Provision 

The bill deletes the requirement that payors of royalties must ex- 
ercise due diligence in obtaining the taxpayer identification num- 
bers of payees of royalties. 



^ Executive Order 12356 is the currently effective Executive order prescribing a uniform 
system for classifying, declassifying, and safeguarding national security information (47 Federal 
Register 14874; April 6, 1982). 



275 

This requirement is eliminated because of its interaction with 
the requirements of backup withholding (Code sec. 3406). Prior to 
the bill, a payor of royalties was required to exercise due diligence 
in obtaining a taxpayer identification number; otherwise the payor 
was subject to a penalty for failure to exercise due diligence. This 
was parallel to the treatment of payors of interest and dividends. 
Payors of interest and dividends are required to impose backup 
withholding if the payee does not certify that the taxpayer identifi- 
cation number is correct. Unlike payors of interest and dividends, 
payors of royalties were not permitted to impose backup withhold- 
ing under these circumstances. The requirement that payors of roy- 
alties exercise due diligence in obtaining taxpayer identification 
numbers is consequently repealed to eliminate this nonparallel 
treatment of royalties. After repeal, payors of royalties are treated 
similarly to payors of other reportable payments subject to backup 
withholding (other than interest and dividend payors). 

8. Estimated tax requirements for tax-exempt organizations (sec. 
115(h) of the bill, sec. 1542 of the Reform Act, and sec. 6154 of 
the Code) 

Present Law 

Present law, as amended by the 1986 Act, requires that estimat- 
ed tax payments of the excise tax on the net investment income of 
private foundations and the tax on unrelated business income of 
tax-exempt organizations be made in accordance with the rules 
generally applicable to corporate estimated tax payments. 

Explanation of Provision 

The bill clarifies that the corporate estimated tax provisions 
(sees. 6154 and 6655) apply to all payments of estimated tax by pri- 
vate foundations. These provisions apply whether the private foun- 
dation is organized as a trust or as a corporation, and whether or 
not the foundation is tax-exempt. Thus, for example, a taxable pri- 
vate foundation organized as a trust will be required to make esti- 
mated tax payments of both the excise tax under section 4940(b) 
and any income tax under subtitle A in accordance with the rules 
of sections 6154 and 6655. The individual estimated tax provisions 
will not apply to any private foundation or tax-exempt trust. "* 

The bill further provides that in the case of a tax-exempt organi- 
zation or a private foundation, the period of underpayment of esti- 
mated tax runs to the 15th day of the fifth month following the 
close of the taxable year (i.e., the due date of the unrelated busi- 
ness income tax return). 



See also section 114(d) of the bill. 



276 

9. Awards of attorney's fees in tax cases (sec. 115(i) of the bill, 

sec. 1551 of the Reform Act, and sec. 7430(c)(2)(A) of the 
Code) 

Present Law 

The prevailing party (other than the United States) in tax cases 
may be ehgible for an award of attorney's fees if it can establish 
that the position of the United States was not substantially justi- 
fied and if other conditions are satisfied, which are generally paral- 
lel to the requirements for an award of attorney's fees under the 
Equal Access to Justice Act (which generally applies in non-tax 
cases). 

Explanation of Provision 

The bill clarifies two cross-references to provisions of the Equal 
Access to Justice Act. First, the bill clarifies that the rules of that 
Act relating to the time period within which a claim for attorney's 
fees must be made also apply to claims in tax cases. Second, the 
bill clarifies that the net worth limitations of that Act (rather than 
parallel provisions elsewhere in the United States Code) apply to 
prevailing parties in tax cases. 

10. Salary of special trial judges (sec. 115(j) of the bill and sec. 
1556 of the Reform Act) 

Present Law 

The salary of special trial judges of the Tax Court is 90 percent 
of the salary of judges of the Tax Court (Code sec. 7443A(d)(l)). The 
President's salary recommendations^ may be construed to have re- 
duced the salary of special trial judges below that 90-percent level. 

Explanation of Provision 

The bill provides that to the extent the President's salary recom- 
mendations are inconsistent with the 90-percent level specified in 
the Code, the recommendations are not effective. 

11. Retirement pay of Tax Court judges (sec. 115(k) of the bill, 
sec. 1557 of the Reform Act, and sec. 7447 of the Code) 

Present Law 

A Tax Court judge's retirement pay is based upon the judge's 
length of service as a judge. A judge who serves on the Tax Court 
at least 10 years receives full retirement pay; the retirement pay of 
a judge serving less than 10 years is proportionately reduced. Time 
served as a judge in recalled status after retirement does not count 
for purposes of computing the 10-year period. 



^ The Budget of the United States Government, 1988, Recommendations for Executive, Legisla- 
tive, and Judicial Salaries, submitted to the Congress on January 5, 1987. 



277 

Explanation of Provision 

The bill provides that service on a substantially full-time basis in 
recalled status after retirement is considered in computing the 10- 
year period. The provision applies for purposes of determining re- 
tirement pay paid after the date of enactment of the bill, regard- 
less of when the services in recalled status after retirement were or 
are performed. 

12. Suspension of statute of limitations during prolonged dispute 
over third-party records (sec. 115(1) of the bill, sec. 1561 of the 
Reform Act, and sec. 7609 of the Code) 

Present Law 

If a dispute between a third-party recordkeeper and the IRS is 
not resolved within six months after the IRS issues an administra- 
tive summons, the statute of limitations is suspended until the 
issue is resolved (sec. 7609(e)). 

Explanation of Provision 

The bill clarifies that this suspension of the statute of limitations 
encompasses disputes with all third-party recordkeepers listed in 
the statute, regardless of whether the summons does or does not 
identify the person with respect to whose liability the summons is 
issued. 

13. Rescission of statutory notice of deficiency (sec. 115(m) of the 

bill, sec. 1562 of the Reform Act, and sec. 6212 of the Code) 

Present Law 

Where the IRS and the taxpayer mutually agree, a statutory 
notice of deficiency may be rescinded. Once the notice has been 
properly rescinded, it is treated as if it never existed. 

Explanation of Provision 

The bill clarifies that rescission of a statutory notice of deficiency 
does not affect any suspension of the running of any period of limi- 
tations during any period during which the rescinded notice was 
outstanding. For example, assume that six months remain to run 
on the statute of limitations with respect to a return when the IRS 
issues a statutory notice of deficiency. Issuance of this notice sus- 
pends the statute of limitations. If the IRS and the taxpayer agree 
to rescind the statutory notice, then as of the date the notice is re- 
scinded, the statute of limitations again begins to run and (in this 
example) six months remains until the statute expires. 

14. General requirement of return, statement, or list (sec. 115(n) 
of the bill and sec. 6011 of the Code) 

Present Law 

When required by regulations, any person liable for any tax or 
the collection thereof must make a return or statement in the 
manner required. 



278 

Explanation of Provision 

The bill clarifies the language of the Code containing this re- 
quirement. 

15. Certain refundable credits to be assessed under deficiency pro- 
cedures (sec. 115(o) of the bill and sec. 62H of the Code) 

Present Law 

Under present law, the deficiency procedures allowing taxpayers 
to litigate issues in the Tax Court relating to the earned income 
credit (sec. 32) and the credit for the certain payments of the gaso- 
line and special fuels tax (sec. 34) may not apply. 

Explanation of Provision 

The bill provides that the Tax Court deficiency procedures apply 
to the credits allowable under sections 32 and 34, notwithstanding 
that the credits reduce the net tax to less than zero. 

The provision applies to taxable years beginning after the date of 
enactment of this bill. 



XVI. Exempt and Nonprofit Organizations (Sec. 116 of the Bill) 

1. Title-holding companies (sec. 116(a) of the bill, sees. 1603 and 
1878(e) of the Reform Act, and sees. 501(c)(25) and 514(c)(9) 
of the Code) 

Present Law 
In general 

The Act provides a new category of tax-exempt organizations, 
consisting of certain corporations or trusts that are organized for 
the exclusive purposes of acquiring and holding title to real proper- 
ty, collecting income from such property, and remitting the income 
(less expenses) from such property to one or more specified catego- 
ries of tax-exempt organizations that are shareholders of the corpo- 
ration or beneficiaries of the trust (Code sec. 501(c)(25)). Such a 
title-holding company is entitled to tax-exempt status only if it has 
no more than 35 shareholders or beneficiaries and has only one 
class of stock or beneficial interest, and only if it meets certain 
other requirements. 

Eligible shareholders or beneficiaries 

Under the Act, the categories of tax-exempt organizations eligi- 
ble to hold interests in a section 501(c)(25) title-holding company 
are (1) a qualified pension, profit-sharing, or stock bonus plan (sec. 
401(a)); (2) a governmental pension plan (sec. 414(d)); (3) the United 
States, a State or political subdivision, or governmental agencies or 
instrumentalities; (4) tax-exempt charitable, educational, religious, 
or other organizations described in section 501(c)(3); and (5) other 
title-holding companies described in section 501(c)(25). 

Rights of eligible shareholders or beneficiaries 

To qualify under section 501(c)(25), the title-holding company is 
required to permit its shareholders or beneficiaries to (1) dismiss, 
after reasonable notice, the corporation's or trust's investment ad- 
visor by majority vote of the shareholders or beneficiaries; and (2) 
terminate their interest by (a) selling or exchanging their stock or 
beneficial interest (subject to Federal or state securities law) to any 
other eligible organization, as long as the sale of exchange does not 
increase the total number of shareholders or beneficiaries to more 
than 35, or (b) redeeming their stock or beneficial interest after 
providing 90 days' notice to the corporation or trust. The Act did 
not expressly provide a sanction for the failure of a title-holding 
company to satisfy the requirements relating to the rights of eligi- 
ble shareholders or beneficiaries. 



(279) 



280 

Unrelated business taxable income 

Exempt organizations are subject to tax on any unrelated busi- 
ness taxable income, including income from debt-financed property. 
(An organization is not precluded from qualifying for tax-exempt 
status merely because it derives unrelated business taxable income, 
so long as the organization is not organized or operated for the pri- 
mary purpose of carrying on an unrelated trade or business.) The 
term debt-financed property means any property held to produce 
income with respect to which there is acquisition indebtedness at 
any time during the taxable year, or during the 12 months prior to 
disposition if the property is disposed of during the taxable year 
(sec. 514(b)). 

Under an exception to the debt-financed property rules, indebted- 
ness incurred by certain tax-exempt organizations (i.e., qualified 
pension plans and certain tax-exempt educational organizations) as 
a result of the acquisition or improvement of real property is not 
considered acquisition indebtedness (sec. 514(c)(9)). The Act ex- 
tended this exception to debt-financed real property held by a sec- 
tion 501(c)(25) title-holding company. 

The Act also provides that an interest in a mortgage is not treat- 
ed as an interest in real property for purposes of the debt-financed 
property rules in the case of real property held by a partnership 
(sec. 514(c)(9)(B)(vi)). 

Explanation of Provision 
Definition of real property 

The bill clarifies the definition of permissible holdings of real 
property by a title-holding company by providing that, for purposes 
of section 501(c)(25), the term real property does not include any in- 
terest as a tenant in common (or similar interest) and does not in- 
clude any indirect interest. This rule ensures a consistent applica- 
tion of the intent of section 501(c)(25) that a title-holding company 
is required to hold real property directly and cannot, for example, 
treat an interest in a partnership, trust, or other entity as an in- 
vestment in real property. 

The bill also provides that for purposes of section 501(c)(25), the 
term real property includes any personal property that is leased 
under, or in connection with, a lease of real property. This excep- 
tion to the general rule that a section 501(c)(25) title-holding com- 
pany may only hold real property applies only if the rent attributa- 
ble to the leasing of such personal property (determined under the 
rules of sec. 856(d)(1)) for the taxable year does not exceed 15 per- 
cent of the total rent for the taxable year attributable to both the 
real and personal property under the lease. 

Eligible shareholders or beneficiaries 

In order to implement the 35-person limitation on shareholders 
or beneficiaries of a section 501(c)(25) organization, the bill deletes 
the provision of the Act that had defined an eligible shareholder or 
beneficiary in a title-holding company to include other section 
501(c)(25) title-holding companies. In lieu of that rule, the bill pro- 
vides that a corporation that is a qualified subsidiary of a section 



281 

501(c)(25) title-holding company is not to be treated as a separate 
corporation for Federal tax law purposes. In the case of such a 
qualified subsidiary, all assets, liabilities, and items of income, de- 
duction, and credit of the qualified subsidiary are treated as assets, 
liabilities, and such items of the title-holding company. 

Under the bill, the term qualified subsidiary means a corporation 
that, at all times while in existence, is wholly owned by the section 
501(c)(25) title-holding company. If a qualified subsidiary subse- 
quently ceases to satisfy the 100-percent stock ownership require- 
ment, the qualified subsidiary is treated, immediately before the 
time it ceases to meet such ownership requirement, as a new corpo- 
ration acquiring all of its assets and assuming all of its liabilities in 
exchange for its stock. 

Rights of shareholders or beneficiaries 

The bill expressly provides that a title-holding company is not 
entitled to tax-exempt status under section 501(c)(25) if it fails to 
permit its shareholders or beneficiaries to dismiss the organiza- 
tion's investment advisor or to terminate their interest in the cor- 
poration or trust in the manner specified in the statute. 

Unrelated business taxable income ■ 

The bill modifies the exception to the unrelated business taxable 
income rules in the case of debt-financed real property owned by a 
section 501(c)(25) title-holding company to provide that the excep- 
tion is not available in the case of a disqualified holder. (Of course, 
a title-holding company does not fail to qualify for tax-exempt 
status merely because its shareholders or beneficiaries have unre- 
lated business income as a result of the operation of this rule.) 

Thus, in computing the unrelated business taxable income of a 
disqualified holder of an interest in a title-holding company, the 
holder's pro rata share of the items of income that are treated as 
gross income derived from an unrelated trade or business (without 
regard to the exception for debt-financed real property) is taken 
into account as gross income of the disqualified holder derived from 
an unrelated trade or business. Further, the holder's pro rata share 
of the items of deductions allowable in computing unrelated busi- 
ness taxable income (without regard to the exception for debt-fi- 
nanced real property) also is taken into account as deductions in 
computing unrelated business taxable income. These iterhs of 
income and deduction are taken into account for the taxable year 
of the holder in which (or with which) the taxable year of the title- 
holding company ends. 

Under the bill, the term disqualified holder means any title-hold- 
ing company shareholder or beneficiary other than either (1) an 
educational institution (described in sec. 170(b)(l)(A)(ii)) or its affili- 
ated support organizations (described in sec. 509(a)(3)) or (2) a quali- 
fied pension trust (within the meaning of sec. 401(a)). 

Under the bill, the rule excluding an interest in a mortgage from 
the definition of real property applies for all purposes under the 
exception for debt-financed real property, rather than solely in the 
case of real property held by a partnership. 



XVII. Miscellaneous Provisions (Sec. 118 of the Bill)* 

1. Tax-exempt entity leasing; deflnition of tax-exempt controlled 

entity (sec. 118(b)(2) of the bill, sec. 1802(a)(2) of the Reform 
Act, and sec. 168(h) of the Code) 

Present Law 

Under the Act, the term "tax-exempt controlled entity" does not 
include a corporation more than 50 percent of the stock in which is 
owned by a foreign person or entity. In addition, in the case of a 
corporation the stock of which is publicly traded, a tax-exempt en- 
tity's holdings are disregarded unless such entity owns at least five 
percent of the stock in the corporation (sec. 168(h)(6)(F)(iii)), 

Explanation of Provision 

The bill clarifies that the amendment applies as if enacted in the 
Tax Reform Act of 1984. 

2. Accrual of interest on certain short-term obligations (sec. 

118(c) of the bill, sec. 1803(a)(8) of the Reform Act, and sec. 
1281 of the Code) 

Present Law 

Under section 1281 of the Code, certain taxpayers are required to 
include in income as interest for a taxable year that portion of the 
acquisition discount or original issue discount on a short-term obli- 
gation that is allocable to the portion of the year during which the 
taxpayer held the obligation. The Act clarified that taxpayers sub- 
ject to the rule for mandatory accrual are required to include in 
income for a taxable year all amounts of interest, irrespective of 
whether the interest is stated or is in the form of discount. The 
amendment made by the Act applies to obligations acquired after 
September 27, 1985. 

Explanation of Provision 

The bill provides that the amendment made by the Act applies 
only to obligations acquired after December 31, 1985. It is under- 
stood that many of the taxpayers affected by the amendment made 
by the Act are small banks that, as a group, customarily file re- 
turns without extension. It is also understood that small banks 
may not have the capacity to develop the required information for 
both 1985 and 1986, in time for the banks to file their 1986 returns 
without extensions. The purpose of the change in effective date is 
to relieve these taxpayers of the administrative burden of identify- 



' Note: Section 117 of the bill contains clerical and conforming changes only. 

(282) 



283 

ing stated interest on short-term obligations acquired after Septem- 
ber 27, 1985 and before January 1, 1986. For obligations acquired 
after December 31, 1985, taxpayers will be required to comply with 
the amendment made by the Act. 

3. Earnings and profits (sec. 118(d)(3) of the bill, sec. 1804 of the 

Reform Act, and sec. 312(b) of the Code) 

Present Law 

The Act clarified the effect on earnings and profits of a distribu- 
tion of appreciated property. 

Explanation of Provision 

The bill provides that the rules relating to the distribution of ap- 
preciated property under section 312(b) do not apply to a distribu- 
tion of a corporation's own obligation. Thus, earnings and profits 
will not be increased by reason of such a distribution. 

4. Treatment of transferor corporation (sec. 118(d)(4) of the bill, 

sec. 1804 of the Reform Act, and sees. 361 and 355 of the 
Code) 

Present Law 

The Tax Reform Act of 1984 generally required that all property 
received by a corporation in a "C" reorganization be distributed. In 
addition, that Act provided that a corporation must recognize gain 
on the distribution of appreciated property to its shareholders in a 
nonliquidating distribution. The 1986 Act made a series of amend- 
ments to the reorganization provisions attempting to conform those 
provisions with changes made by the 1984 Act. However, numerous 
technical problems with the 1986 amendments have arisen. The bill 
responds to these technical problems with a complete revision of 
the 1986 amendments. 

Explanation of Provision 

Treatment of reorganization exchange. — The bill restores the pro- 
visions of section 361, relating to the nonrecognition treatment of 
an exchange pursuant to a plan of reorganization, as in effect prior 
to the amendments made by the 1986 Act. Thus, as under prior 
law, gain or loss will generally not be recognized to a corporation 
which exchanges property, in pursuance of the plan of reorganiza- 
tion, for stock and securities in another corporation a party to the 
reorganization. However, as under prior law, gain will be recog- 
nized to the extent the corporation receives property other than 
such stock or securities and does not distribute such other property 
pursuant to the plan of reorganization. ^ 

The bill amends prior law by providing that transfers of property 
to creditors in satisfaction of the corporation's indebtedness in con- 
nection with the reorganization are treated as distributions pursu- 
ant to the plan of reorganization for this purpose. ^ The Secretary 



1 This could occur, for example, where liabilities are assumed in a transaction to which sec- 
tion 357(b) or (c) applies. 

2 This overrules the holding in Minnesota Tea Company v. Helvering, 302 U.S. 609 (19d8). 



284 

of the Treasury may prescribe regulations necessary to prevent tax 
avoidance by reason of this provision. This amendment is not in- 
tended to change in any way the definition of a reorganization 
within the meaning of section 368. 

Treatment of distributions in reorganizations. — The bill also con- 
forms the treatment of distributions of property by a corporation to 
its shareholders in pursuance of a plan of reorganization to the 
treatment of nonliquidating distributions (under section 311). 
Under the bill, the distributing corporation generally will recognize 
gain, but not loss, on the distribution of property in pursuance of 
the plan of reorganization. However, no gain will be recognized on 
the distribution of "qualified property". For this purpose, "quali- 
fied property" means (1) stock (or rights to acquire stock) in, or the 
obligation of, the distributing corporation and (2) stock (or rights to 
acquire stock) in, or the obligation of, another corporation which is 
a party to the reorganization and which were received by the dis- 
tributing corporation in the exchange. The bill also provides that 
the transfer of qualified property by a corporation to its creditors 
in satisfaction of indebtedness is treated as a distribution pursuant 
to the plan of reorganization.^ 

Basis. — The bill clarifies that the basis of property received in an 
exchange to which section 361 applies, other than stock or securi- 
ties in another corporation a party to the reorganization, is the fair 
market value of the property at the time of the transaction (pursu- 
ant to section 358(a)(2)). Thus the distributing corporation will rec- 
ognize only post-acquisition gain on any taxable disposition of such 
property received pursuant to the plan of reorganization. Of course, 
the other corporation will recognize gain or loss on the transfer of 
its property under the usual tax principles governing the recogni- 
tion of gain or loss. 

Treatment of section 355 distributions. — Finally, the bill provides 
that the rules of section 311 shall apply to the distribution of prop- 
erty in a section 355 transaction which is not in pursuance to a 
plan of reorganization. Thus, gain (but not loss) will be recognized 
on the distribution of property other than the stock or securities in 
the controlled corporation in a transfer to which section 355 (or so 
much of section 356 as relates to section 355) applies. For this pur- 
pose, the gain recognition provisions of section 311(b) will not apply 
to the distribution of securities notwithstanding that the recipient 
rnay be taxed by reason of the excess principal amount rule of sec- 
tion 355(a)(3)(A), but the gain recognition rule will apply to stock 
which is not permitted to be received tax-free under section 355(a). 

5. Golden parachutes (sec. 118(d)(5)-(7) of the bill, see. 1804(j) of 
the Reform Act, and sec. 280G of the Code) 

Present Law 

Under present law, no deduction is allowed for "excess parachute 
payments" (sec. 280G) and a nondeductible 20-percent excise tax is 
imposed on the recipient of any excess parachute payment (sec. 
4999). 



' These amendments are not intended to affect the treatment of any income from the dis- 
charge of indebtedness arising in connection with a corporate reorganization. 



285 

The term parachute payment does not include any payment 
made to (or for the benefit of) a disqualified individual (1) with re- 
spect to a corporation that was, immediately before the change in 
control, a small business corporation (as defined in sec. 1361(b), re- 
lating to S corporations) or (2) with respect to a corporation no 
stock of which was, immediately before the change in control, read- 
ily tradable on an established securities market, or otherwise, pro- 
vided shareholder approval was obtained with respect to the pay- 
ment to a disqualified individual. 

The Secretary may, by regulations, provide that a corporation 
fails to meet the requirement that it have no stock that is readily 
tradable if a substantial portion of the assets of any entity consists 
(either directly or indirectly) of stock in the corporation and inter- 
ests in the entity are readily tradable on an established securities 
market, or otherwise. 

Congress was concerned that, absent specific rules, a taxpayer 
might utilize the exemption for shareholder approval to avoid the 
golden parachute provisons by creating tiers of entities. Such avoid- 
ance is possible if the gross value of the entity-shareholder's inter- 
est in the corporation constitutes a substantial portion of such enti- 
ty's assets. Congress contemplated that, in such cases, the Secre- 
tary will adopt regulations requiring approval of the owners of the 
entity rather than the approval of the entity itself. Of course, such 
shareholder approval may be obtained only if the entity sharehold- 
er also has no stock that is readily tradable. 

The Secretary is authorized to prescribe such regulations as may 
be necessary or appropriate to carry out the purposes of the golden 
parachute provisions. 

Explanation of Provision 

Under present law, a corporation could fail to qualify for the 
shareholder approval exception if it has nonvoting preferred stock 
that is publicly traded, even if all common stock of the corporation 
is not publicly traded. In some cases, an interest in preferred stock 
is more in the nature of debt rather than equity. 'The purpose of 
the golden parachute provisions is to protect equity shareholders 
whose interest in the corporation could be impaired by parachute 
payments to disqualified individuals. No protection is necessary in 
the case of nonvoting preferred stock if the preferred shareholders 
receive the redemption or liquidation value to which they are enti- 
tled. 

Thus, the bill provides that, for purposes of the shareholder ap- 
proval requirements, the term "stock" does not include any stock 
(1) that is not entitled to vote, (2) that is limited and preferred as to 
dividends and does not participate in corporate growth to any sig- 
nificant extent, (3) that has redemption and liquidation rights 
which do not exceed the issue price of such stock (except for a rea- 
sonable redemption or liquidation premium), (4) that is not convert- 
ible into another class of stock, and (5) the rights of which are not 
adversely affected by the parachute payments. 

The bill addresses several issues that arise in the application of 
the shareholder approval requirements for a corporation the stock 
of which is not publicly traded by expanding the Secretary's regu- 



286 

latory authority under the golden parachute provisions. It is ex- 
pected that regulations will address these issues, particularly the 
application of the shareholder approval requirements in the case of 
shareholders that are not individuals (i.e., the shareholders are 
partnerships, corporations, or other nonindividual entities), and to 
what extent nonvoting interests in the entity shareholder have the 
right to affect the approval of that shareholder. In general, it is an- 
ticipated that the normal voting rights of the entity shareholder 
will determine whether or not the entity shareholder approves the 
parachute payments. For example, limited partners with no right 
to vote on partnership issues generally would not be entitled to 
vote with respect to the partnership shareholder's approval of a 
parachute payment. 

The bill specifically authorizes the Secretary to prescribe regula- 
tions addressing the application of the shareholder approval re- 
quirements to entity shareholders that hold de minimis amounts of 
stock in the corporation. Of course, shareholder approval would 
still be required if the corporation constituted a substantial portion 
of the assets of the entity shareholder. 

For purposes of the small business exception, the bill provides 
that "small business corporation" is defined as in section 1361(b) 
but without regard to paragraph (1)(C) thereof (relating to nonresi- 
dent aliens). In the golden parachute context, the effect of the use 
of the small business corporation definition was to treat domestic 
corporations less favorably to the extent they were owned by for- 
eign persons rather than U.S. persons. Because less favorable treat- 
ment was accorded to these corporations solely because they were 
owned by foreign persons (as contrasted to U.S. corporations whose 
shareholders were not taxable by the United States), this golden 
parachute provision discriminated against foreign persons and 
would have violated certain U.S. treaties. 

6. Settlement funds (sec. 118(e) of the bill, sec. 1807(a)(7) of the 
Reform Act, and sec. 468B of the Code) 

Present Law 

A taxpayer generally may deduct qualified payments to a desig- 
nated settlement fund at the time such payments are made. A 
qualified payment does not include any amount which may be 
transferred from a designated settlement fund to the taxpayer. The 
taxpayer may not hold a beneficial interest in the income or corpus 
of the fund. 

Explanation of Provision 

The bill clarifies that a qualified payment does not include any 
amount which may be transferred from a designated settlement 
fund to any person related to the taxpayer. 

The bill also clarifies that a designated settlement fund (1) must 
extinguish completely the taxpayer's tort liability with respect to a 
class of claimants, and (2) must not under its terms provide a bene- 
ficial interest in the income or corpus of the fund to any person 
related to the taxpayer. 



287 

7. Treatment of stripped tax-exempt bonds (sec. 118(p)(4) of the 
bill, sec. 1879 of the Reform Act, and sec. 1286(d) of the Code) 

Present Law 

In determining the basis of a stripped coupon or stripped bond 
relating to a tax-exempt obligation under present law, the holder 
makes adjustments to basis to account for the accrual of original 
issue discount ("OID"). The total adjustment to basis on account of 
OID is an amount not in excess of that amount which produces a 
yield to maturity equal to the lower of (1) the coupon rate on the 
tax-exempt obligation, or (2) the yield to maturity of the stripped 
coupon or stripped bond. 

Explanation of Provision 

Under the bill, in the case of a tax-exempt obligation from which 
one or more coupons have been stripped, a portion of OID with re- 
spect to any stripped coupon or stripped bond (as determined under 
the general coupon stripping rules) is treated as OID on a tax- 
exempt obligation. OID in excess of the "tax-exempt portion" is 
treated as OID on an obligation that is not a tax-exempt obligation. 

Under the bill, the tax-exempt portion of the OID with respect to 
a stripped coupon or stripped bond relating to a tax-exempt obliga- 
tion is the excess of the stated redemption price at maturity (or in 
the case of a coupon, the amount payable on the due date of the 
coupon), over an issue price that would produce a yield to maturity 
as of the purchase date (of the stripped coupon or stripped bond) 
equal to the lower of (1) the coupon rate on the tax-exempt obliga- 
tion from which the coupons were separated, or (2) the yield to ma- 
turity (on the basis of the purchase price) of the stripped coupon or 
stripped bond. The taxpayer can elect to use the original yield to 
maturity instead of the coupon rate for these purposes. 

For example, assume that a tax-exempt obligation with a face 
amount of $100 due January 1, 1990, and with a coupon rate of 10 
percent (compounded semiannually) is issued for $100 on January 
1, 1987, and is stripped on January 1, 1988. The right to receive the 
principal amount is sold for $79.21 reflecting a yield to maturity at 
the time of the strip of 12 percent (compounded semiannually). 
Under the bill, the tax-exempt portion of discount on the stripped 
bond is limited to $17.73, the difference between the stated redemp- 
tion price ($100) and the issue price that would produce a yield to 
maturity of 10 percent ($82.27). This portion of the discount is 
treated as OID on a tax-exempt obligation. 

The amount of discount on the stripper bond in excess of the tax- 
exempt portion is $3.06, equal to the excess of total discount 
($20.79) over the tax-exempt portion. This portion of the discount is 
treated as OID with respect to an obligation that is not a tax- 
exempt obligation. 

The total amount of OID allocable to the accrued period ending 
on July 1, 1988, with respect to the stripped-bond is $4.75 (6 percent 
of $79.21), of which $4.11 is treated as OID on a tax-exempt obliga- 
tion (5 percent of $82.27) and $0.64 ($4.75 minus $4.11) is treated as 
OID on an obligation that is not a tax-exempt obligation. The hold- 



288 

er's basis for the bond is increased to $83.96 ($79.21 issue price plus 
accrued discount of $4.75). 

The provision is effective for any purchase or sale of a stripped 
coupon or stripped bond relating to a tax-exempt obligation after 
June 10, 1987. Present law remains in effect for any purchase or 
sale of any such stripped coupon or bond after October 21, 1986, 
and before June 11, 1987. Present law also remains in effect in the 
case of any person who, on June 10, 1987, held for sale in the ordi- 
nary course of such person's trade or business any obligation or 
coupon in stripped form, with respect to any sale of such obligation 
or coupon by such person, and with respect to any such obligation 
or coupon while held by another person who purchased such obliga- 
tion from the person who held such obligation or coupon on June 
10, 1987. 

8. Reorganizations of investment companies (sec. 118(o)(5) of the 

bill, sec. 1879 of the Reform Act, and sec. 368 of the Code) 

Present Law 

The Act provided that stock of a RIC, REIT, or diversified invest- 
ment company will not be treated as stock of a single issuer for 
purposes of determining whether the holder is diversified within 
the meaning of section 368(a)(2)(F)(ii). The legislative history of that 
amendment provided that the provision was intended to permit an 
investment company to be treated as a diversified investment com- 
pany only if it would be so defined if it were deemed to own its 
ratable share of the assets of any RIC, REIT, or diversified invest- 
ment company in which it owns stock (without regard to whether 
its percentage ownership is 50 percent or more). 

Explanation of Provision 

The bill conforms the statutory language to the legislative histo- 
ry of the Act. The bill provides that, for purposes of determining 
whether a corporation is diversified, a person holding stock in a 
RIC, REIT, or diversified investment company shall, except as oth- 
erwise provided in regulations, be treated as holding its proportion- 
ate share of the assets held by the RIC, REIT, or diversified invest- 
ment company. It is anticipated, for example, that the regulations 
may provide for exceptions in de minimis cases. 

9. Elimination of duplicative Medicare tax provisions for certain 

State and local government employees (sec. 118(o) of the bill, 
sec. 1895 of the Reform Act, and sec. 3121(u) of the Code) 

Present Law 

Under Code section 1402(c), certain employees of State or local 
governments who are compensated solely on a fee basis are subject 
to the self-employment (SECA) tax, including the Medicare portion 
of that tax. The Consolidated Omnibus Budget Reconciliation Act 
of 1985 (P.L. 99-272) extended Medicare coverage and tax to State 
and local government employees hired after 1985, effective for serv- 
ice performed after March 31, 1986 (Code sec. 3121(u)). No excep- 



289 

tion was provided for certain State and local government employ- 
ees who were already subject to Medicare tax under section 1402(c). 

Explanation of Provision 

The bill provides an exception to the Medicare tax provision in 
Code section 3121(u) for individuals holding a position described in 
section 1402(c)(2)(E), effective for services performed after March 
31, 1986. 



TITLE II. TECHNICAL CORRECTIONS TO OTHER TAX 
LEGISLATION 

A. The Superfund Revenue Act of 1986 (Sec. 201 of the Bill) 

1. Tax on chemical feedstocks (sec. 201(a) of the bill, sec. 513 of 
the Superfund Act, and sec. 4662 of the Code) 

Present Law 

Under present law, tax is imposed on the sale (by the manufac- 
turer, producer, or importer) of 42 organic and inorganic chemical 
feedstocks. If the manufacturer, producer, or importer of a taxable 
chemical feedstock uses the feedstock, then tax is imposed on the 
use of the feedstock in the same manner as if the feedstock had 
been sold. 

Under the "mixed stream" rule, no tax is imposed on the sale or 
use of any taxable organic chemical while such chemical is part of 
an intermediate hydrocarbon stream containing a mixture of tax- 
able organic chemicals. Where tax is not imposed by reason of the 
mixed stream rule, the subsequent isolation, extraction, or removal 
of a taxable chemical from an intermediate hydrocarbon stream is 
treated as a taxable use. 

A credit or refund (without interest) may be allowed or made to 
the taxpayer for tax paid with respect to a taxable chemical feed- 
stock which is (1) exported, or (2) used to make a listed taxable sub- 
stance which is exported. No credit or refund is allowed unless the 
person who paid the tax either has agreed to repay the tax to the 
exporter, or has obtained the written consent of the exporter waiv- 
ing such repayment. 

Explanation of Provisions 

Refunds directly to exporter 

Under the bill, the Secretary is required to issue regulations pro- 
viding the conditions under which credit or refund (without inter- 
est) may be allowed or made to the exporter of a taxable chemical 
or listed taxable substance, rather than to the person who paid the 
tax, where the taxpayer waives his right to receive the refund and 
the exporter provides such information as may be required by the 
Secretary. Such conditions may include (1) a requirement that the 
exporter and the person who paid the tax register with the Inter- 
nal Revenue Service, (2) a requirement that the exporter provide 
written evidence that the taxpayer has waived its right to the 
refund, and (3) the time, place, and manner in which claims for 
refund or credit are to be made. 



(290) 



291 

Mixed stream rule 

The bill clarifies that the present law treatment of intermediate 
hydrocarbon streams applies where the stream contains one or 
more taxable organic chemical feedstocks and one or more nontax- 
able organic chemicals. Thus the mixed stream rule is not limited 
to mixtures containing two or more taxable organic chemical feed- 
stocks. The term "intermediate hydrocarbon stream" generally 
means a mixture of organic chemicals which is subject to further 
distillation or processing in the manufacture of a taxable chemical. 

2. Broadbase environmental tax (sec. 201(b) of the bill, sec. 516 of 

the Superfund Act, and sees. 59A and 882 of the Code) 

Present Law 

Under present law, an environmental tax is imposed on corpora- 
tions equal to 0.12 percent on the excess of modified alternative 
minimum taxable income ("AMTI") for the taxable year over $2 
million. Modified AMTI means AMTI as defined for purposes of the 
corporate alternative minimum tax without regard to the alterna- 
tive net operating loss and environmental tax deductions. 

Although regulated investment corporations ("RICs") and real 
estate investment trusts ("REITs") are passive investment entities, 
they are classified as corporations and may have corporate alterna- 
tive minimum taxable income. 

Explanation of Provisions 

RICs and REITs 

The bill clarifies that the environmental tax does not apply to 
RICs and REITs. 

Foreign corporations 

The bill clarifies that a foreign corporation engaged in a trade or 
business within the United States is subject to the environmental 
tax on its income which is effectively connected with the conduct of 
a trade or business within the United States. 

3. Leaking Underground Storage Tank Trust Fund tax (sec. 201(c) 

of the bill, sec. 521 of the Superfund Act, and sees. 4041, 4042, 
and 4081 of the Code) 

Present Law 

Under present law, an additional 0.1 cent per gallon tax is im- 
posed on gasoline, diesel, special motor fuels, and other liquid fuels 
that are otherwise subject to fuels excise taxes. This tax also is im- 
posed on any liquid used, or sold for use, as a fuel in a diesel-pow- 
ered train. Revenues from this tax are used to finance the Leaking 
Underground Storage Tank ("LUST") Trust Fund. The additional 
tax generally is imposed on the same tax base and is collected in 
the same manner as the other excise taxes on these fuels (Code 
sees. 4041, 4042, and 4081). The tax is not imposed on liquified pe- 
troleum gas. 



292 

Explanation of Provisions 
Tax on diesel fuel may be imposed on sale to retailer j 

The bill clarifies that the 0.1 cent per gallon LUST tax on diesel ! 
fuel is imposed upon sale to a qualified retailer in situations where 
the tax on diesel fuel for highway vehicle use is imposed on such 
sale. 

Liquids used in aviation 

The bill clarifies that the 0.1 cent per gallon LUST tax applies to 
all liquids used, or sold for use, as fuel in an aircraft, but that the 
LUST tax is not to be imposed twice (i.e., by reason of both sections 
4041 and 4081). The bill also clarifies that the additional tax im- 
posed by section 4041(c) on gasoline used as a fuel in noncommer- 
cial aviation is computed without regard to the LUST tax, and thus 
is not reduced by the LUST tax. 

Exempt sales 

The bill clarifies that gasoline which is used as a fuel in an air- 
craft or in a train is not exempt from the LUST tax by reason of 
section 6421 (relating to off-highway business use and sales of gaso- 
line for certain other exempt purposes). 

Floor stock tax 

The bill clarifies that certain gasoline which on January 1, 1988 
is held by a dealer is to be subject to a floor stocks tax at a rate of 
9.1 cents rather than 9 cents per gallon. This ensures that the 0.1 
cent per gallon LUST tax is collected on such gasoline. The reve- 
nue attributable to the additional floor stock tax is to be trans- 
ferred to the Leaking Underground Storage Tank Trust Fund. The 
bill further clarifies that the penalty and other provisions of law 
applicable to section 4081 taxes also apply to the floor stock tax. 



B. The Harbor Maintenance Revenue Act of 1986 (Sec. 202 of the 

Bill) 

1. Tax rate for fuel used on inland waterways (sec. 202(a) of the 
bill, sec. 1404(a) of the Harbor Revenue Act, and sec. 4042(b) 
of the Code) 

Present Law 

The Superfund Revenue Act of 1986 (P.L. 99-499), as enacted on 
October 17, 1986, imposed an additional, separate "Leaking Under- 
ground Storage Tank Trust Fund financing rate" of 0.1 cent per 
gallon on fuel subject to the existing inland waterways fuel tax 
(Code sec. 4042). The Harbor Maintenance Revenue Act of 1986 
(P.L. 99-662), enacted on November 17, 1986, amended section 4042 
to provide a gradual increase in the rate of waterways fuel tax, the 
revenues from which are transferred to the Inland Waterways 
Trust Fund. In restating the increased tax rates in section 4042(b), 
this subsequent amendment failed to include the 0.1 cent per 
gallon additional tax rate (for the Leaking Underground Storage 
Tank Trust Fund) that had been enacted the previous month. 

Explanation of Provision 

The bill provides that for purposes of Code section 4042 (inland 
waterways fuel tax), the amendment made by the Superfund Reve- 
nue Act of 1986 relating to the separate 0.1 cent per gallon tax for 
the Leaking Underground Storage Tank Trust Fund is to be treat- 
ed as enacted after the amendment to section 4042 made by the 
Harbor Maintenance Revenue Act of 1986. 

The bill therefore reinstates the separate 0.1 cent per gallon tax 
rate (in sec. 4042) for the Leaking Underground Storage Tank 
Trust Fund, as if included in the Harbor Maintenance Revenue Act 
of 1986. Thus, the additional 0.1 cent per gallon fuel tax is effective 
as of January 1, 1987, i.e., the effective date for such tax as enacted 
in the Superfund Revenue Act. 

Exemption from the harbor maintenance tax for cargo trans- 
ported between U.S. possessions, etc. (sec. 202(b) of the bill, 
sec. 1402(a) of the Harbor Revenue Act, and sec. 4462(b) of 
the Code) 

Present Law 

A new harbor maintenance tax (Code sees. 4461-4462) was im- 
posed under the Harbor Maintenance Revenue Act of 1986 (P.L. 99- 
662), effective April 1, 1987. The tax is 0.04 percent of the value of 
commercial cargo loaded or unloaded at U.S. ports. 

Under section 4462(b), the tax does not apply to (1) cargo loaded 
on a vessel in a U.S. mainland port for transportation to Alaska, 

(293) 



294 

Hawaii, or a U.S. possession for ultimate use or consumption there- 
in; (2) cargo loaded on a vessel in Alaska, Hawaii, or a U.S. posses- 
sion for transportation to the U.S. mainland for ultimate use or 
consumption therein; (3) unloading of such cargo (described in (1) or 
(2), above) in Alaska, Hawaii, or any U.S. possession or in the U.S. 
mainland, respectively; or (4) cargo loaded on a vessel in Alaska, 
Hawaii, or a U.S. possession and unloaded in the State or posses- 
sion in which loaded. The exception does not apply to crude oil 
cargo with respect to Alaska. 

Explanation of Provision 

The bill provides a specific exemption in section 4462(b)(1)(B) for 
cargo transported between U.S. possessions, between U.S. posses- 
sions and Alaska or Hawaii, and between Alaska and Hawaii. The 
amendment is effective as if included in the Harbor Maintenance 
Act of 1986 (i.e., as of April 1, 1987). 



C. The Omnibus Budget Reconciliation Act of 1986 (Sec. 203 of the 

Bill) 

1. Exclusion of discharge of indebtedness income in determining 
tax-exempt status of mutual or cooperative telephone and elec- 
tric companies (sec. 203(a) of the bill, sec. 1011(a) of the Omni- 
bus Budget Reconciliation Act of 1986, sec. 623 of Public Law 
99-591, and sec. 512(c)(12)(A) of the Code) 

Present Law 

Under present law, benevolent life insurance associations of a 
purely local character, mutual ditch or irrigation companies, 
mutual or cooperative telephone companies, or like organizations 
are exempt Federal income tax (other than on unrelated business 
taxable income) so long as 85 percent or more of the income of the 
organization consists of amounts collected from members for the 
sole purpose of meeting losses and expenses (Code sec. 501(c)(12)). In 
the case of mutual or cooperative telephone companies, the 85-per- 
cent test is determined without regard to income received or ac- 
crued from (1) nonmember telephone companies for the perform- 
ance of communication services with members, (2) certain pole 
rentals, and (3) the sale of display listing in a directory furnished 
to members. In the case of mutual or cooperative electric compa- 
nies, the 85-percent test is determined without regard to income re- 
ceived or accrued from certain pole rentals. 

Also under present law, gross income includes "income from dis- 
charge of indebtedness" (sec. 61(a)(12)). A discharge of indebtedness 
is considered to occur whenever a taxpayer's debt is forgiven, can- 
celled, or otherwise discharged by a payment of less than the prin- 
cipal amount of the debt. The amount of the indebtedness dis- 
charged is equal to the difference between the face amount of the 
debt, adjusted for any unamortized premium or discount, and any 
consideration given by the taxpayer to effect the discharge. 

Section 1011(a) of the Omnibus Budget Reconciliation Act of 1986 
and section 623 of Public Law 99-591 provided that certain loans 
made pursuant to sections 306 A, 306B, or 311 of the Rural Electrifi- 
cation Act of 1936 could be prepaid at an amount less than the 
principal amount of the debt. 

Explanation of Provision 

The bill provides that, in the case of mutual or cooperative tele- 
phone companies or electric companies, the 85-percent test of sec- 
tion 501(c)(12) is to be determined without regard to any income 
from discharge of indebtedness arising from the prepayment of a 
loan under section 306A, 306B, or 311 of the Rural Electrification 
Act of 1936, as in effect of January 1, 1987. 

(295) 



296 

2. Payment period for excise taxes on imported beverages and to- 
bacco products (sec. 203(b) of the bill, sec. 8011 of the Omnibus 
Budget Reconciliation Act of 1986, and sees. 5061 and 5073 of 
the Code) 

Present Law 

The excise taxes on alcoholic beverages and tobacco products are 
imposed on removal of a taxable product from bonded premises. 
Tax on domestically produced articles (and distilled spirits import- 
ed in bulk) is paid with respect to semi-monthly periods, with tax 
being due 14 days after the close of each semi-monthly period. Tax 
on imported products (other than distilled spirits imported in bulk) 
is due 14 days after the date on which the taxable product enters 
the customs territory of the United States. 

Explanation of Provision 

The bill conforms the payment periods for excise taxes imposed 
on imported alcoholic beverages and tobacco products generally to 
those presently applicable to domestic products. Thus, tax on these 
imported products will be paid with respect to semi-monthly peri- 
ods, with tax being due 14 days after the close of each semi-month- 
ly period. 

O